Will the RBI cut rates?

Now that the growth in the Index of Industrial Production has spurted to 8.2 per cent, many are wondering if the Reserve Bank of India (RBI) will begin to start reducing interest rates.

A review is due on December 18. To figure out whether or not it will, it is necessary to understand the linkages in the system. The answer depends on whether industrial production varies with the cost of money or with demand. How important are interest rates in the overall cost structure of a company? Not very, because they constitute only about 3 per cent of total revenues.

So, while a reduction in interest rates may lead to a revival of investment after a lag of 16-18 months, the impact on current industrial production will be very limited.

The key to industrial revival lies in the revival of demand that has been flagging because both firms and people are not spending as much as they could. There are two ways of getting them to spend more.

One is to simply pump money into their pockets; the other is to get the rate of inflation down so that more money is left over for spending on cars, fridges, mobile phones and the like. The RBI’s first duty is to keep inflation down. So, it will not take any action that will serve to increase it.

This means that it will not lower interest rates by any significant amount because lower rates will mean higher borrowings and greater spending. The problem, however, is that inflation is still running at a very high level. More money to spend will mean an immediate upward pressure on inflation because supply takes time to catch up. On balance, therefore, it is reasonable to expect the RBI not to cut rates in December.

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