The Link Between Interest Rate and Inflation Rate

The Reserve Bank of India, decided to keep the benchmark interest rates of the economy unchanged. The decision was taken after three days of deliberations by the Monetary Policy Committee of the RBI.

There was an expectation for the RBI to cut the report rate given the increasingly worsening forecast about India’s economic growth.

To be sure, forecasts for India’s gross domestic product (GDP) growth have been rolled back sharply ever since Covid-19 disruption hit the economy.

At present, most experts expect the economy to contract sharply in the current financial year. There were others who expected the RBI to stay put and avoid cutting the repo rate because retail inflation had been above the RBI’s comfort zone for most of this calendar year.

As more and more money chases the existing set of goods, prices of such goods rise. In other words, inflation (which is nothing but the rate of increase in prices) spikes.

To contain inflation, a country’s central bank typically nudges up the interest rates in the economy. By doing so, it incentivises people to spend less and save more because saving becomes more profitable as interest rates go up.

As more and more people choose to save, money is sucked out of the market and inflation rate moderates.

When growth contracts, as was happening right through 2019, then typically, people’s incomes also get hit. As a result, less and less money is chasing the same quantity of goods.

In such situations, a central bank nudges down the interest rates so as to incentivise spending and by that route boost economic activity in the economy.

Lower interest rates imply that it is less profitable to keep one’s money in the bank or any similar saving instrument. As a result, more and more money comes into the market, thus boosting growth and inflation.

RBI is facing an odd situation at present:
GDP is contracting even as inflation is rising. This is happening because the pandemic has reduced demand, on the one hand, and disrupted supply on the other.

It is true that for containing inflation, RBI should raise interest rates. And under normal circumstances, it would have done just that. But raising interest rates at this stage would be catastrophic for India’s GDP growth.

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