The downside impact of reducing the interest rate did not go unmentioned. The interest rate difference between US and India used to be about 4% in 2000 and now the differential is about 1.5%.

The minutes of the monetary policy committee (MPC) was concluded on February 7, 2025 have many revelations. They have repeatedly referred to the Union Budget 2025-26 and acknowledged the need for RBI to be in the same direction with a cut in the repo rate by 25 basis points.

It is admitted that economic slowdown is observed since October 2024 and rate cut was warranted. The need to support the housing demand, and demand for durable consumption goods with a rate cut is admitted. So, the private investment will spur a lowered cost of debt. The target rate cut was suggested to be even 50 basis points at this juncture itself.

On the cost of borrowing for MSMEs, it is shared that the ratio of interest to EBITDA for smaller companies is higher. Significant number and volume of loans to large industries are in MCLR (marginal cost of lending rate) regime. However, since almost all the MSME loans are linked to External Benchmark Rate (EBR), a rate cut by the RBI will benefit the MSME sector sooner. Coupled with the policy rate cut, ensuring sufficient liquidity will lower the weighted average lending rate (WALR) and together may address the growth slowdown issue.

While thumb rule perception is that a 10% depreciation in rupee will cause an increase of inflation by 0.5%, MPC shared that as per the balance of risks, a depreciation of rupee by 5% will cause CPI (Consumer Price Index) inflation rise by 35 basis points. However, the GDP (Gross Domestic Product) growth will rise by 25 basis points due to short term stimulation of the exports supported by competitive rupee.

It is also shared that the low growth rate of real wages caused subdued private consumption and lower economic growth. High interest rates reduce demand. On the other hand, the high interest rate raises the risk premium in the loans to the capital investments. Thus, relatively higher interest rates are a drag on the growth from both sides.

Food inflation is a supply side phenomenon. History showed that the repo rate hardly has any impact on the food prices or their volatility. Therefore, when the headline inflation is higher mostly due to higher food prices, holding the repo rate higher will have a negative impact rather than a positive impact.

The downside impact of reducing the interest rate did not go unmentioned. The interest rate difference between US and India used to be about 4% in 2000 and now the differential is about 1.5%. With such a lower differential in the interest rates, after considering the hedging and other transactional costs, the alpha for the debt capital flowing into India will be negative. Therefore, US dollar inflows get affected with the lower interest rate differential.

In fact, at present the flow of dollar investments are not happening solely due to interest rate differentials only. Therefore, the MPC had justifiably chosen to ignore the impact of interest rate differential and caused a repo rate cut by 25 basis points. Whether or not the situation remains conducive and whether or not RBI will reduce interest rate by another 25 basis points in its April 2025 meeting need to be watched for, alongside the evolving domestic and international situations.

Dr. Kishore Nuthalapati Economist and a Corporate Finance Professional