10-February-2025-Editorial

REPO RATE CUT BY RBI: REASONS AND IMPLICATIONS

The Reserve Bank of India (RBI) has reduced the repo rate from 6.5% to 6.25% (a 25 basis points cut) for the first time in five years. This decision comes in the wake of the Union Budget 2025-26, which introduced personal income tax reductions to boost consumption. The repo rate cut is aimed at reviving economic growth amid signs of a slowdown.

Reasons for the Repo Rate Cut

Growth-Oriented Union Budget

• The Union Budget 2025-26 reduced personal income tax and revised TDS limits, increasing disposable income for individuals.
• By lowering borrowing costs, the repo rate cut complements the government’s tax measures, encouraging spending and investment.

Declining Inflation Trends

• The Consumer Price Index (CPI) inflation fell to 5.22% in December 2024, down from 5.48% in November, marking a four-month low.
• Lower inflation creates room for monetary easing without the risk of excessive price increases.

Improving Market Liquidity

• The RBI injected Rs 1.5 trillion into the banking system to improve liquidity.
• The repo rate cut further ensures that credit remains affordable and accessible, preventing a liquidity crunch.

Global Economic Challenges

• Recent US tariffs on Canada, Mexico, and China have raised concerns of a global trade war, impacting financial markets.
• The rupee weakened to 87.29 per US dollar, increasing inflation risks.
• A lower repo rate can help stabilize domestic economic conditions and mitigate external uncertainties.

About Repo Rate

The repo rate (Repurchase Agreement Rate) is the interest rate at which commercial banks borrow funds from the RBI.

It is a short-term borrowing tool that helps banks maintain liquidity.

How It Works

• Banks provide government securities as collateral and agree to repurchase them later at a higher price, which includes interest.

Impact on Borrowing and Spending

• Higher repo rate: Increases borrowing costs, making loans expensive and reducing spending.
• Lower repo rate: Reduces borrowing costs, making loans affordable and increasing economic activity.

Role in Monetary Policy

• The repo rate is used to regulate inflation, money supply, and overall economic growth.

Impact of the Repo Rate Cut

Boost to Economic Growth

• Lower interest rates make loans cheaper, encouraging businesses to expand and invest.
• Increased investments lead to higher production, job creation, and economic activity.

Increased Consumer Spending

• With lower loan EMIs, individuals have more disposable income to spend on goods and services, stimulating demand.

Effects on Financial Markets

• Banks may lower interest rates on savings accounts and fixed deposits, making them less attractive.
• This could shift investments towards stocks, mutual funds, and real estate.

Impact on Exports and Currency Value

• Lower interest rates can lead to capital outflows as investors seek higher returns elsewhere.
• This may weaken the rupee, making Indian exports more competitive but increasing import costs.

Risk of Rising Inflation

• Increased borrowing and spending could push up demand, leading to higher prices.
• The RBI must balance growth with its inflation target of 4% (±2%).

Background: India’s 4% Inflation Target

Chakravarty Committee (1982-85)

• Led by Sukhamoy Chakravarty, it was set up to review monetary policy.
• Key recommendations:

• Prioritized price stability as a major goal of monetary policy.
• Proposed a 4% annual inflation target in the Wholesale Price Index (WPI).
• Suggested market-driven government borrowing to reduce reliance on RBI funding.
• Advocated monetary targeting using M3 money supply control.

• M3 Formula: M1 (Currency + Demand Deposits in Banks) + Net Time Deposits.

Urjit Patel Committee (2014)

• Established India’s formal inflation-targeting framework.
• Fixed a 4% inflation target with a ±2% tolerance band.
• Adopted in 2016, aligning India with global monetary policy best practices.

Conclusion

The RBI’s repo rate cut is a strategic move to support economic growth, aligning with the government’s fiscal measures. While it reduces borrowing costs and encourages spending, the challenge remains to control inflation and maintain financial stability. Continuous monitoring and policy adjustments will be key to ensuring sustainable economic expansion.