Interest Rate

Keynes’s supposition of short-term interest rates as the key driver of long-term government bond yields is investigated for India, after controlling for various key economic factors. It is seen that long-term interest rates of Indian government bonds are positively associated with the short-term interest rates of Treasury Bills. Higher long-term interest rates on IGBs are influenced by higher short-term interest rates, higher rates of inflation, a faster pace of industrial production and higher fiscal deficit (and vice versa). The bond market was disrupted during 2013 when yields rose sharply in India. Incorporating this structural break improved our findings.

The politics and economics of interest rate formation in this country must be studied carefully. Lowering the interest rate raises stock prices in an environment where they themselves cannot move up thanks to the fundamentals of the economy that are not conducive.

An examination of the Reserve Bank of India's monetary policy leaves little doubt that India can be suitably characterised as an endogenous money economy. In an endogenous money environment, financial reforms will prove ineffective in stimulating credit supply to large commercial borrowers. They may, however, prove counterproductive by sharpening the credit constraints faced by agricultural and other petty producers in the economy.

.

The reduction in the Bank rate and in the cash reserve ratio effected in the latest credit policy statement may appear small, but what is significant is the signal conveyed to the market that the policy of supporting investment by providing adequate liquidity and a softer interest rate environment will continue.