RBI cuts interest rates, says inflation outlook uncertain, GDP growth negative

https://www.livemint.com/news/india/rbi-cuts-interest-rates-by-40-basis-points-repo-rate-now-4-
11590121168184.html
Date of article: 22 May 2020

NEW DELHI: The Reserve Bank of India (RBI) on Friday cut repo rate by 40 basis
points (bps) to 4% from 4.40% and reverse repo by as much to 3.35% from 3.75%.
The bank rate stands reduced to 4.25%. The announcement was made by RBI
governor Shaktikanta Das in a 10am TV broadcast. 1 bps is one hundredth of a
percentage point.

The decision was taken by the Monetary Policy Committee (MPC) of the central
bank today after a three-day long meeting. The MPC was forced to meet ahead of its
3-5 June scheduled meeting as liquidity continued to be tight in the money market,
despite the central banks' previous steps of cutting interest rates and various policy
measures.

The decision was reached after a 5:1 vote at the MPC meet with Chetan Ghate the
lone voice calling for a 25 bps cut. Das said the world economy is headed into a
recession.

The MPC decision to cut key interest rates comes after the central bank's previous
attempt to make banks increase lending to consumers, non-banking finance
companies (NBFCs) and mutual funds (MFs) have failed to make an impact. Inflation
outlook is highly uncertain, the MPC felt, according to Das. Headline inflation could
ease later and by Q3 (October-December) and Q4 (January-March) could fall below
4%, its target set earlier. Supply shock to food prices may linger, the MPC felt and
called for re-appraisal of import duties.

"Deficient demand may hold down pressures on core inflation (excluding food and
fuel), although persisting supply dislocations impart uncertainty to the near term
outlook. However, volatility in financial markets could have a bearing on inflation.
These factors, combined with favourable base effects, are expected to take effect
and pull down headline inflation below target in Q3 and Q4 of 2020-21," Das said in
his address.

GDP growth in FY21 is expected to remain in negative territory, Das said, even as
he didn't give a growth forecast. Goldman Sachs on 17 May said India’s economy
may contract by a huge 45% in the June quarter and the projected 5% fall in GDP for
2020-21 will be deeper compared to all “recessions" India has ever experienced.

"Recovery in economic activity is expected to begin in Q3 and gain momentum in Q4

as supply lines are gradually restored to normalcy and demand gradually revives.
For the year as a whole, there is still heightened uncertainty about the duration of the
pandemic and how long social distancing measures are likely to remain in place and
consequently, downside risks to domestic growth remain significant," the governor
said.
The article talks about the Indian economy suffering with negative GDP growth due

to the pandemic amongst other world economies. GDP growth in India is expected to

continue trending negatively with high chances of entering recession owing to

sustained negative economic growth for more than two quarters. GDP growth

indicates growth in real GDP in an economy over a period of time.

Although the output increases due to increased supply, the downside risks of

economic growth are very high. This suggests fall in aggregate demand in the

economy, hence, the government used expansionary monetary policy by cutting

interest rate by 40 basis points by reserve bank of India (RBI) to avert recession.

Monetary policy involves changing interest rate and/or money supply by Central

Bank to achieve macroeconomic objectives. Interest rate is the rates at which

borrowers are charged or lenders pay for loan.1

A decrease in bank rate (lending rate charged by Central Bank from commercial

banks2) by 4.25% will translate into lower interest rates for firms and households.

This makes borrowing attractive while discouraging saving. Low interest rates

causes decreased borrowing costs encouraging firms to increase borrowing causing

increased investment in Indian Economy. Further, due to fall in interest rate, hot

money inflow will decrease, as foreign investors won’t be interested in depositing

money in Indian banks, causing demand for INR to decrease, depreciating its value.

This’ll makes Indian exports cheaper and more competitive however, imports will

become expensive indicating a favourable trade balance. Thus, three components of

AD: net export, investment and consumption will increase, and AD curve will shift

right.
1
“2.5 Monetary Policy.” The IB Economist, ibeconomist.com/revision/2-5-monetary-policy/.
2
What Is Bank Rate? Definition of Bank Rate, Bank Rate Meaning.
economictimes.indiatimes.com/definition/bank-rate.
 Desirable impact of expansionary monetary policy on Indian economy

LRAS
Price Level SRAS
in India

PL1

PL3

PL2

AD1 (Pre-covid)

AD3

AD2 (Post-covid)
Ye Ye1 Yp rGDP of
India
Recessionary Gap

As the graph indicates, initially the economy was operating at its potential where AD 1

intersected the SRAS curve, hence rGDP was Y p. Due to Covid many people lost

jobs and some observed fall in income leading to low purchasing power causing AD

to shift left. Consequently, rGDP became Ye with fall in price level from PL1 to PL2.

This causes recessionary gap represented by Yp-Ye as at this point rGDP is less than

potential GDP. As a solution, central bank reduces interest rates as part of

expansionary monetary policy to increase aggregate demand from AD2 to AD3

resulting in higher rGDP Ye1 thus reducing the recessionary gap.

The article states that Indian economy may contract by 45% in the June quarter and

there may be a 5% fall in GDP for 2021, since the contraction is due to decrease in

AD therefore expansionary demand-side policies are expected to be more effective.

However, there is a trade-off associated with demand side policies represented in

diagram above. Although, reduction in interest rates helped boost AD and increase

rGDP but consequently there is an increase in price level from PL2 to PL3 resulting in

Demand-Pull Inflation. Demand-pull inflation describes upward pressure on

prices due to increase in AD that follows a shortage in supply. 3 The trade-off

can be exhibited through Phillips-curve. The short-run Phillips curve shows a

negative relationship between unemployment rate and inflation rate.

Short-run Philips Curve in Indian Economy

A fall in interest rate causing AD to increase would help the economy reduce its

cyclical unemployment (unemployment resulting from falling AD), consequently

unemployment rate reduces from U1 to U2 but this would be accompanied by rise in

inflation rate from IA to IB depicted in the diagram above. However, RBI believes that
3
Chen, James. “Demand-Pull Inflation Definition.” Investopedia, Investopedia, 12 Feb. 2021,
www.investopedia.com/terms/d/demandpullinflation.asp.
despite the interest rate cut, AD may not increase enough, and core inflation might

continue to stay low. Core inflation is the underlying rate of inflation which eliminates

certain goods and services with highly volatile prices. Though there are still chances

of increase in price level due to supply disruptions. Thus, overall inflation scenario

remains uncertain.

RBI has rightly decreased interest rate will help boost AD. However, lower interest

rate may not translate into higher AD as low consumer confidence would result in no

increase in borrowing despite low interest rates. Therefore, Indian government

should prefer using expansionary fiscal policy by increasing government spending

and cutting taxes along with monetary policy. However, during recession, increase in

government spending would be advisable as money spending will increase boosting

consumer confidence increasing consumption and investment. Thus, expansionary

Fiscal policy would also cause AD to increase. However, advantages of monetary

over fiscal policy are ability of quick implementation without any political processes

and it doesn’t impact government budget. However, for long term economic growth

the government must impose supply side policies.

Word Count: 749

BIBLIOGRAPHY
“2.5 Monetary Policy.” The IB Economist, ibeconomist.com/revision/2-5-monetary-

policy/.

What Is Bank Rate? Definition of Bank Rate, Bank Rate Meaning.

economictimes.indiatimes.com/definition/bank-rate.

Chen, James. “Demand-Pull Inflation Definition.” Investopedia, Investopedia, 12 Feb.

2021, www.investopedia.com/terms/d/demandpullinflation.asp.