July 09 2020
RBI: on the horns of a dilemma
21 January 2019

Must the central bank cut interest rates or only change its stance in the February policy review?

After changing the stance of the monetary policy in the October review meeting to ‘calibrated tightening’ from ‘neutral’, the Reserve Bank of India (RBI) under Shaktikanta Das may choose to change the stance back to ‘neutral’ again in the February review meeting, after retail inflation grew at the slowest pace in 18 months. December retail inflation came in at 2.19% on the back of softening food and fuel prices.

The monetary policy committee (MPC) of the RBI decided to keep the key interest rate unchanged at 6.5% in the policy review meeting in December. Amid slowing retail inflation and sluggish economic growth, the clamour for a rate cut has gained momentum with the industry bodies, which met Mr. Das last week, suggesting a 50 basis point (bps) interest rate cut along with similar reduction in the cash reserve ratio requirements of banks. (100 basis points = 1 percentage point).

“We continue to expect the RBI MPC to cut rates by 25 bps on February 7 (and 25-50 bps in 2019) with December inflation coming in at a low 2.2%, atop November’s 2.3%,” Bank of America Merrill Lynch (BofAML) said in a note to its clients.

If the RBI decides to lower the interest rate, a change in stance to ‘neutral’ will only be natural. A neutral stance would mean there is a scope for interest rates to move either way, as opposed to calibrated tightening which means rates can only go up.

Inflation assessment

Even if the RBI is guided by headline inflation numbers for policy-making purposes, the divergence in major components of inflation creates the dilemma of whether to lower the rate or not.

In a speech on Friday at the Vibrant Gujarat Summit, the RBI Governor acknowledged that the divergences and volatility among the components becomes a challenge for assessment of inflation. Some of the major components like inflation in food, fuel, and inflation excluding food and fuel, have shown wide divergences.

This apart, though food inflation has turned negative since October 2018 and fuel inflation has been highly volatile, inflation, excluding food and fuel, remains sticky at close to 6%.

“A change in stance is more likely now and a rate cut may have to wait for couple of months,” Soumya Kanti Ghosh, group chief economic adviser, State Bank of India told The Hindu. “RBI has said they focus on headline inflation numbers but core inflation has stayed elevated,” added Mr. Ghosh, who thinks there is only an outside chance of a rate cut.

BofAML, however, said even if core inflation hardened to 5.4% from 4.9% last month, it should reverse with oil and commodity prices coming off. “We track January inflation at 2.7% with food deflation persisting,” the report said.

What adds to the dilemma is the upcoming Budget on February 1. Traditionally, election years have seen only a vote-on-account in which no major announcements are made. However, this year could be an exception as Finance Minister Arun Jaitley indicated at a recent event.

“The convention has always been that the election year budget normally is an interim budget and ordinarily there should be no reason why we should move away from that convention. But then, the larger interest of the economy always dictates what goes into the interim budget and that’s something which cannot be discussed or disclosed at this stage,” Mr. Jaitley said at the CNBC-TV18 India Business Leader Awards on Thursday.

There is the expectation of a major announcement from the government for the rural economy due to the stress faced by the farm sector. If that happens, then RBI would like to watch for implications on inflation as well as on fiscal deficit.

There has already been a debate as to whether the government should stick to the fiscal deficit target of 3.3% of GDP when the economy actually needs a stimulus to boost growth.

‘Expansionary policy’

BJP’s economic affairs spokesman, Gopal Krishna Agarwal, told The Hindu there is scope for expansionary policy when inflation is low. “Over the years, we have brought the fiscal deficit down and the fiscal prudence was very good. Inflation, which was in double digits, has been reduced to 2.2% and [is] under control.

“But there are some distressed sectors like agriculture, MSMEs which are in need of desperate support from the government. The current situation specifically says liquidity is required in the economy, distress sectors need to be taken care of, banks need to expand credit, and there is a resource constraint from the government side. So, I think there is a scope for expansionary policy when inflation is under control,” Mr. Agarwal said.

Interestingly, Mr. Das, who spoke on a wide range of issues at the Vibrant Gujarat Summit, avoided making any observations on fiscal deficit. Probably, he will also wait for the budget to make up his mind.



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