Factors Influencing Interest Rates

These financial assets have a structure of interest rates which should be rationally based on the degree of risk of ownership, uncertainty of return, period of maturity and a host of other factors.

The factors which influence interest rates on various financial investments are the nature of the instrument, maturity period, risk, tax status, marketability and liquidity.

Interest Rates in India

Most of the interest rates in India are controlled and administratively fixed. It would, therefore, be difficult to isolate the free market forces which influence the interest rates in India. So far, interest rate policy has been used as a support to other instruments of monetary policy in India. Even under these controlled conditions, the basic postulates that interest rates are influenced by the money, liquidity and the rates of inflation etc. hold good particularly in uncontrolled unorganised market

Bank Rate and Refinance Rates

In the organized sector of the financial system for which data are available, interest rate policy is set by the actions of the Central Bank as its discount rate (viz., Bank rate is the leader of interest rates). In India, the bank rate is the discount rate at which the central bank of the country makes advances to the commercial and co-operative banks against eligible assets.

Section 49 of the RBI Act defines Bank Rate as the standard rate at which the Bank is prepared to buy and discount bill of exchange or other commercial paper eligible for purchase under the Act. In view of the limited role of the money market and bill market in India, the Bank rate is not the real leader among the interest rates. Under Section 17 of the RBI Act, the Reserve Bank provides refinance through various windows at different rates. It is these refinance rates which are the discount rates of the central bank in India.

The weighted average rate of interest on these various types of refinance would be the effective rate of discount by the RBI. This is different from the Bank rate. The multiplicity of rates is necessitated by the social obligations of the banking system and the nature of our financial system.

Money Market Rates

Next to the Bank rate, the other short-term rates of significance are the Treasury Bills rate and Call Money rate. The 91-day Treasury bill rate has remained frozen for years at 4.6% but

From January 1993 this rate was freed. This is because there is no market for Treasury Bills in India and the instrument is used for the purpose of financing government expenditure. As such this rate has no significance for the general structure of interest rates. Treasury bills of 182 days sold on auction basis since 1987 bear higher rates which are more realistic and market-oriented.

As regards call money rate, it has no doubt some relevance• to the money market conditions, as the stringency or otherwise of the banks’ funds is reflected in this market. The ceiling rate was fixed at 10% in April 1980 but was removed in May 1989. Since then the rates fluctuated daily depending on the demand and supply conditions.

Main factors influencing interest rates

• Economic growth rate vs underlying trend rate. If the underlying trend rate is 2.5%, economic growth above this target is likely to cause inflationary pressure.
• Spare capacity. A key test is the amount of spare capacity in the economy, though this can be difficult to calculate. For example, in a recession how much potential capacity is lost?
• Wage inflation. Rising wages lead to higher costs for firms and higher spending. This is a very important factor as it can be self-reinforcing leading to a wage price spiral.
• High unemployment tends to depress wage inflation and therefore keep inflationary pressure low.
• Commodity prices. Rising commodities will tend to increase inflation. However, some commodities have a tendency to be volatile meaning it is more unreliable as a guide to underlying inflation.
• Exchange Rate. A depreciation in the exchange rate will cause inflationary pressures. This is because imports become more expensive, and there will be greater demand for exports.
• House prices. House prices do not directly influence the CPI. However, rising house prices causes a positive wealth effect and therefore higher consumer spending
• Consumer confidence. Higher confidence leads to higher spending.