RBI releases bi-monthly monetary policy statement giving out its interest rate decision, after gauging various factors like consumer confidence, households’ inflation expectations, corporate sector performance, credit conditions, the outlook for the industrial, services and infrastructure sectors, global economy situation.
Prices of goods/services are determined by its demand and supply conditions at domestic & global level. As supply of money in the economy increases, the demand for goods/services rise, thus putting an upward pressure on the prices. Headline inflation reflects prices of essential consumption goods including fuel. As we are aware, RBI targets inflation through its monetary policy, interest rate being one of prime tools.
When actual inflation crosses target inflation, monetary policy is directed towards decreasing the supply of money in the economy which is done through increase in interest rate (Repo rate- the rate at which RBI lends money to the banks).
During the 2018, interest rate was increased twice by 25 bps from 6.00% to 6.50% (exhibit A). Changes in RBI chair, resultant expansionary monetary policy in tandem with softening inflation (exhibit B), interest rates in year 2019 are reduced back to 6.00%. Fall in interest rates increases the money supply in economy. Coupled with this, rising oil prices increases the fuel cost would result in rising headline inflation.
If oil prices are expected to remain in this range or higher, inflation is expected to rise. With inflationary pressure back in force, stance of monetary policy might be changed to Contractionary, resulting in increase in the interest rates in coming months.
Increase in crude prices increases the import cost for Oil Marketing companies. The USD import bill of nation rises, thus widening the Current Account Deficit. CAD for Q3-2018 is already as high as 2.5% of GDP. The negative trade balance puts an upwards pressure on USD as demand in India grows for making external payments. This puts a downward pressure on Rupee.
Although increased interest rates is meant to attract capital flows in the economy, as for the emerging nations, high interest rates is perceived as a negative indicator of potential slowing economy’s performance due to rising inflation, slowing growth, resulting in capital outflows of the economy, thus, depreciating the local currency further.
Rupee depreciation makes imports costlier. Also, external borrowings become costlier. Oil companies being an import oriented enterprise, it is highly vulnerable to fluctuations in oil prices, rupee volatility. Local Debt financing increases the exposure to local interest rates hike. Many projects of oil companies are financed through external debt, i.e. External commercial borrowings (ECBs), bonds floated outside India. Rupee depreciation will increase the external debt cost. With potential global slowdown and recession being counted on, the global interest rate movements, global currency fluctuations should be closely monitored. All these factors makes it difficult for the enterprise to seek additional financing. Increase in inputs costs and finance cost, increases the operating and financial leverage for the enterprise, making it more vulnerable to exposure to external factors.
Hence, increase in the interest rate has multi-fold impact on household, manufacturing & service sector, eventually affecting the growth of the economy. The magnitude of impact depends on the level of increase & time period for which nation experiences the high interest regime.
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