To Cut or Not to Cut, that is the Question for the RBI Tomorrow

Feb 6, 2019

Sarvajeet Bodas, Research analyst, The 5 Minute Wrapup

The last Monetary Policy Committee (MPC) was uneventful. The RBI kept the repo rate unchanged.

The MPC is the committee that decides the interest rate policy of the RBI. Their next meeting is scheduled for tomorrow.

The market is worried the RBI won't cut interest rates.

Now, in that last meeting, former RBI governor, Urjit Patel made an important statement...

  • Should upside risks (to inflation), not materialise on a durable basis in the coming months, there is possibility of space opening up for policy action in due course.

This basically means if inflation remains under control, then there is a scope for interest rate reduction.

So, with that backdrop, tomorrow's MPC meeting will be an interesting one.

The reason?

Inflation is falling.

As per the recent data, CPI-based retail inflation declined to an 18-month low of 2.2% in December.

Importantly, since August last year, inflation has stayed below RBI's inflation target of 4%.

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Low global crude prices, higher food production and the adoption of an inflation targeting framework have all contributed to this outcome.

But, this is a unique situation for India.

As a developing nation and fast-growing economy, we are used to high inflation. The current inflation numbers are similar to the numbers seen in developed nations such as USA and Japan.

If high inflation was the challenge earlier, low inflation is also a dilemma for the RBI.

You see, due to low inflation, the real interest rate (i.e. nominal interest rate - inflation) has increased substantially.

If the nominal interest rate is 8% and inflation is 6%, then the real interest rate is 2%.

Earlier, this rate was close to zero. And in the high inflation scenario in 2012-13, this was negative. But currently, the real interest rate is around 4.6%.

The real interest rate is important because it is strongly correlated to investment.

As per a study by the RBI, a 1% increase in the real interest rate leads to a decline of about 0.5% in the investment rate.

This is because a high real interest rate is good for savers. People and businesses choose to save rather than invest.

This is not conducive for the capex revival.

Given this, will the RBI cut the repo rate at the next MPC meeting starting tomorrow?

The answer would have been a big YES if the government would have maintained its fiscal deficit target of 3.3% for the year FY19.

But hey, it's an election year.

In the interim budget, the government has revised the fiscal deficit for FY19 to 3.4%. Not to mention, for FY20 too, the fiscal deficit is estimated to be 3.4%.

The fiscal deficit is the difference between what the government spends and what it earns. A higher fiscal deficit means more borrowing by the government to cover its expenses.

And that creates an upward pressure on interest rates.

Similarly, the budget focused on boosting consumption with the help of tax relief. People will have more money to spend. This in turn, will put an upward pressure on inflation.

This has created a tricky situation for the RBI which follows an 'inflation-targeting' policy.

Considering this, the possibility of repo rate cut looks low at the moment.

But then, Ravindra Dholakia, one of the members of the MPC, made an interesting statement during the last meeting...

  • RBI's own downward revision of the forecast of inflation 12 months ahead to a substantial extent is a clear indication of their long-term impact on the economy. Thus, a policy response is called for. If there is no policy action in response to such a major favourable shock, MPC would run the risk of being considered neither current nor relevant!

Regarding fiscal deficit, he said:

  • Fiscal slippage is possible but the extent of it may not warrant any panic because its impact on inflation may not be significant and will be felt, if at all, with a considerable lag.

To echo Hamlet... to cut or not to cut is the question the RBI faces regarding interest rates.

Chart of the day

In 2016, the RBI adopted an inflation target of 4% (+/-2%) for next five years under the monetary policy framework.

However, as I mentioned earlier, since August last year, inflation has stayed below RBI's target of 4%.

Actual Inflation has Stayed Below the RBI's Target

In fact, in December, CPI-based retail inflation declined to an 18-month low of 2.2%.

Currently, the RBI's policy stance was 'calibrated tightening'.

But with the recent inflation data, the MPC may change its monetary stance to 'neutral', even if it does not cut the repo rate.

Sarvajeet Bodas
Sarvajeet Bodas (Research Analyst)
Co-editor, Smart Money Secrets

PS: Sarvajeet Bodas and Radhika Pandit, co-editors of Smart Money Secrets, are getting ready to recommended their next stock. If you haven't subscribed to Smart Money Secrets yet... you can do so here.

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