On the face of it, MSMEs, the government’s new focus area for faster economic growth, will be benefited. But, will the commercial banks be able to sustain such rate cuts at a time when retail inflation has been showing a steady growth over the last eight months to attract higher term deposits at lower rates? Shouldn’t RBI now raise the bank rate to control inflation? Banks would love to operate in a situation where demand for credit is high and deposits match the credit demand. If banks went slow in responding to earlier RBI rate cuts, they were obviously concerned that lower deposit rates will affect their deposit inflows and automatically choke credit outflows.

While the credit growth is easing, the deposit slowdown trend is a matter of concern. Bank credit in India is expected to grow at 13-14 per cent on average between FY19 and FY20, significantly faster compared with the eight per cent in FY18, which would force a change in the deposit mobilisation plans of banks over the medium term, feels experts at CRISIL Ratings. To meet such a demand for credit growth, banks will have to raise about Rs 25 lakh crore over the two fiscals, observe the experts.

And, higher retail inflation rate combined with lower deposit rates could act as a spoiler. The retail inflation continues to climb. In June 2019, it reached an eight-month high of 3.18 per cent. The inflation rate moved up further, last month. The retail inflation, calculated on the basis of Consumer Price Index (CPI), has been on the rise since January this year.

Economists will agree that inflation and interest rates are highly linked and frequently referenced in macroeconomics. Traditionally, high interest rates in India have been the result of high inflation rates. The high inflation rates ate into the value of the Indian currency, Rupee, in real terms. However, higher interest rates did not affect the economic growth. During the early part of the 1980s, when the domestic banks’ lending rates with surcharge topped the record 20 per cent level, the country’s industrial growth was close to the double digit figure.

Despite a comparably much lower lending rates in the last five years, the growth of the industrial production index has been very low, around four per cent. India's Industrial production rose only 3.1 per cent YoY in May 2019. India's Industrial production index growth rate YoY data is updated monthly, available from April 2006, with an average growth rate of 4.5 per cent, much below the GDP growth rate. Banks are cautious. The government’s meddling with ‘borrowers’ interest’ over the years has, in a way, corrupted the country’s banking system, often promoting ‘cut-money’ and ‘kickback’ practices leaving banks with large non-performing assets (NPAs).

Generally speaking, at lower interest rates, more people are able to borrow more money. Consumers get more money to spend, causing the economy to grow and, in the process, inflation to increase. Higher interest rates hold the opposite. Consumers tend to save more as returns from savings are higher. Disposable income contracts and inflation decreases. Under the fractional-reserve system of banking, interest rates and inflation tend to be inversely correlated. This relationship is one of the central tenets of contemporary monetary policy. Central banks manipulate short-term interest rates to affect the rate of inflation in the economy. Inflation control is the primary objective of the central bank while the government’s key objective is economic growth. That is why a central bank’s role to push economic growth, ignoring the inflationary trend, is viewed with suspicion.

The quantity theory of economics states that the supply and demand for money determines inflation. If the money supply grows, prices tend to rise, because each individual piece of currency paper becomes less valuable. The interest rate acts as a price for holding or loaning money. Banks’ interest rate on savings is meant to influence depositors. The theory says lower lending rates induces higher demand for loans, increasing money supply and resulting in inflation over a period of time. On the contrary, higher interest rates tend to lower inflation. It explains how interest rates and inflation tend to be inversely correlated.

More than interest rate reduction, what will improve the domestic industrial growth is high government spending and focus on a self supporting economy rather than relying on import of capital and goods. This is not happening. The government is not spending enough to boost the economy. The business is still highly import dependant of capital, goods and services. Let the central bank do its job to control inflation. And, the government would do well to take measures to expand the economy, raise industrial production, push up exports and create more lucrative job opportunities for its citizens. Let us not ignore that India’s economy is doing quite well. Inflation has not choked the growth of borrowings.
(IPA Service)