The Inherent Interest: What the Rate Cut Unfolds?

 Backdrop: The Recent Macroeconomic Outlook

The Indian economy, poised on a growth spree since the COVID-19-induced curbs were lifted, has seen a slight downward spiral. The growth trajectory, set on an onwards and upward scale, halted in Q2 FY25. The halt was primarily driven by the slowing of manufacturing output, muted demand, and lackluster investment. A reduced public investment due to general elections in 2024 further crippled the growth outlook. Prices haven’t been easy either. The world’s fastest-growing major economy has been facing food inflation as high as 8–9%, with inflation constantly ranging around 6-7% levels in the previous quarters. However, there has been some relief with the recent data showing it around 4.5% for January. The Union Budget for 2025–26 attempted to boost consumption while also ensuring fiscal consolidation. The fiscal deficit was estimated to be 4.8% of the GDP for the preceding fiscal year, with the target for the upcoming year being 4.4%.

The Rate Cut: Need and Implications

A central bank generally cuts interest rates in order to boost the demand in the economy. A rate cut puts more money into the hands of the people. With higher liquidity, the demand for commodities rises, and with the same level of supply, the overall price level in the economy tends to increase. Interest rates can also be used as a tool for taming inflation. Raising them takes away money from the hands of the people. With less money and constant supply for commodities, the demand for commodities falls and the overall price level decreases. Hence, cutting rates has to be an exercise that needs to be undertaken keeping in mind the potential impact on prices. 

The Reserve Bank of India reduced the repo rate from 6.5% to 6.25%. The repo rate is the rate at which the central bank lends to commercial banks to meet their short-term needs. The EMIs of the loans that the banks lend are indexed against these benchmark interest rates. As the interest rates reduce, the borrowers are required to pay less on their EMIs. With an extra amount being in the pockets of the commoners, this gets injected into the economy, spurring consumption and boosting aggregate demand. Another implication of rate cuts pertains to the liquidity aspect. As commercial banks are now required to keep less reserves with the central bank, they can lend more with the extra money. This extra money goes into the economy and helps in stirring demand through investment. Rate reduction also reduces the cost of borrowing for banks. This helps boost private and corporate investment further. 

What lies ahead: Fiscal expansion

The interest rates slashed by the RBI have been 25 basis points (1 percentage point = 100 basis points). With the reduction being marginal, it is not expected to affect the economy broadly. With just a 0.25% decrease, the EMIs will be witnessing a fall of not more than INR 1000. This poses an interesting caveat: will the rate cut be able to meet its intended objective? 

The answer lies in current inflation and the most accurate approach to tame it. The current inflation is supply-side inflation, driven by supply chain bottlenecks. The most notable being the Russia-Ukraine war and the crisis in the Middle East. These constraints make it difficult to cope with the monetary policy, whose primary target is liquidity. The solution lies in fiscal stimulus, similar to the ones given by the government during COVID-19. The 76,000-crore semiconductor package is one such notable example. 

Epilogue

According to Revenue Secretary Tuhin Kanta Pandey, fiscal and monetary policy have to work in tandem to achieve India’s goal of being a developed nation by 2047, when the world’s largest democracy celebrates the centenary year of her independence.  The rate cut is a first step in this direction. It has to be well complemented by fiscal expansion.