It is no secret that the economy is in bad shape due to the prolonged lockdown. However, the RBI has a lot of power to mitigate such economic crises. So, six wise men of the Monetary Policy Committee (MPC) of the Central bank are about to conduct a 3-day meeting to decide whether policy rates should be cut and if yes, then by how much. One might think these complex rate cuts affect only businesses and people in the finance domain and not normal people like ourselves.
But it affects each one of us albeit through a few layers and often disproportionately.
Rate Cuts - An important weapon in the RBI’s arsenal
Policy rates simply indicate the rate at which the RBI lends to financial institutions like banks. If these rates are cut, banks can borrow at lower rates. And then these banks can afford to lend on the cheap to businesses and individuals. This will lead to people borrowing more to invest in businesses and taking loans for vehicles, housing etc. Basically more jobs, more money in the system, leading to more economic output.
But rate cuts come with their fair share of problems as well. Too much free money in the system will eventually lead to inflation. Which means the value of your currency goes down or simply put - everything now becomes more expensive for all of us.Then what should the RBI do?
Now, the easy solution here would be that we should go for rate cuts but only to the extent that there is not too much liquidity. But all this is well and good in theory. It does not exactly work this way in real life as it goes through several hiccups along the way. For instance, even after cutting policy rates, banks are not willing to lend to us at lower rates. And that is exactly what has happened over the past few months.
The RBI has cut policy rates by 1.15% since February, but banks have lowered their average lending rates by just 0.72%. Banks fear that due to the difficult environment, more and more of their money might not come back which they may have to write off. So they are not reducing the lending rates to keep a certain amount of cushion. Another problem is that of the inflation rate. RBI strictly tries to keep the retail inflation rate in between 2% - 6% and currently inflation stands at 6.09%. Any further rate cut might increase that number.
So our economists are divided as to whether there should be any rate cuts. Those seeking rate cuts are expecting the rate to be cut to 3.5% - 3.75% from the current 4%.
The RBI has so far prioritized revving up the economic engine and not stressed too much on the inflation rate due to the unprecedented situation it faces. It has projected a negative GDP growth rate for next financial year and will do everything to minimize the damage. So it is likely that the RBI will cut rates to some extent.
If rate cuts do happen then it can turn out to be a #Teji move as it looks like many businesses are going to face a cash crunch in months to come. But due to conservative stance of the banks, banks may not pass on the rates to their customers, which continues to remain a problem.This needs to be resolved for the rate cuts to have the intended impact on the economy.