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Will Interest rates respond to higher Inflation?

Jun 7, 2000

The actual cost of borrowed money is, as we know, not the same as the real cost of money. The actual cost (nominal interest) has two components – the real cost of money and anticipated inflation rates. The relationship can be stated as: NI = RI + E ; where NI is nominal rate of interest, RI is the real interest and E is the expected inflation rate.

Now given that the NI remains the same and the E increases, the real cost of money should decrease. That’s the scenario that we are witnessing (infact the decline in nominal rates in recent months has further lowered real rates). This is beneficial to corporates as they are able to maximise profits (product prices are rising faster than the cost of capital). Lower real rates spur demand in an economy. Just a couple of years back the scenario was the exact opposite. Then the E was declining while the NI remained constant. This resulted in higher real costs of borrowing thus hampering investment activity in the corporate sector.

So, is the current scenario an ideal one, where real interest rates are on the decline? No. That’s because higher inflation means higher prices (as stated earlier). According to a study by Dr C Rangarajan, Ex Governor of the RBI, inflation rate not higher than 6 – 6.5% is acceptable in India. A higher rate would affect the economy in several ways – higher prices would mean a loss of competitiveness in international markets, thus hurting exports and consequently the value of the Indian Rupee. Then as someone said, the most effective way to quell poverty is to limit inflation.

The RBI would in all probability respond to the rising inflation rate, unless it cools off on its own. The scenario for now seems unlikely as international crude prices continue to be high and beyond the control of Indian government. Therefore the need to raise nominal interest rates (which will lead to higher real rates, given the same level of expected inflation) to cool off demand in the economy. The RBI would probably not rush into hiking interest rates as the recovery in investment activity is still nascent. But then, inflation in India is a big political issue. Therefore be prepared for a hardening of interest rates in coming months.

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