Cheaper Credit Doesn’t Always Spell Faster GDP Growth

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Context

The ongoing debate regarding a reduction in the repo rate highlights the complexities of monetary policy and its impact on economic growth, particularly in the context of India’s inflation and GDP growth targets.

Controversy Surrounding Repo Rate Reduction

Introduction to the Issue: There are growing calls for a reduction in the repo rate to stimulate potential growth, despite the current inflation concerns and the RBI's growth projection of 7.2% for the year.
Impact on Investment: High interest rates are expected to slow down investment as companies borrow less, yet business opportunities and capacity utilization rates often have a greater influence on investment decisions.
Historical Context: Despite high interest rates in the past, robust bank credit growth was observed, indicating that factors other than the repo rate also significantly influence GDP growth.

Global Comparisons and Inflation Context

Inflation Target Variations: India's central inflation target is 4%, higher than the 2% target in Western economies, due to factors like dependence on monsoon rains and government pricing policies affecting food prices.
Repo Rate Historical Data: Historically, India’s repo rate has been high, averaging 6.28% for the 60 months preceding the pandemic, compared to 5.1% for the last 51 months when the rate was significantly lowered.
Real Interest Rate Analysis: The real repo rate, calculated as the difference between the repo rate and CPI inflation, averaged -0.81% during the pandemic period, highlighting the nuanced understanding required in interpreting nominal vs. real interest rates.

Policy Implications and Future Directions

Repo Rate Fairness: The current nominal repo rate of 6-6.5% is considered fair under normal conditions, with potential adjustments if inflation remains stable around 4%.
Real Repo Rate Considerations: With the real repo rate currently around 1%, significant reductions in inflation would be necessary to justify a rate cut.
Inflation Trajectory: The RBI’s primary mandate is inflation control within a 2% band around the 4% target, making sustained low inflation crucial for any future monetary policy decisions.

UPSC Mains Questions

Q. Discuss the role of the repo rate in influencing investment decisions and GDP growth in the Indian economy. How do other factors like business opportunities and capacity utilization interact with interest rates?

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