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Inflation & interest rate interaction - Outside View by S.S. TARAPORE

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Inflation & interest rate interaction
Aug 11, 2014

The Reserve Bank of India (RBI) Monetary Policy Review of August 5, 2014, maintained the level of policy interest rates, centred on the eight per cent overnight repo rate (i.e. the rate at which the RBI provides overnight money to banks against the collateral of government securities). There has been futile debate as to whether the August 2014 policy was less hawkish or more hawkish than the June 2014 policy. The simple fact is that policy interest rates remained unchanged. Bisecting and dissecting the policy and attempts to read between the lines can sometimes be counter-productive.

Inflation and interest rates

As against the Consumer Price (CPI) target of an inflation rate of eight per cent for January 2015, the latest year-on-year rate is 7.3 per cent. Just because the latest observation was a little below the January 2015 inflation objective, it did not warrant a reduction in policy interest rates, as there are upside risks of a pass-through of administered price increases, some concern about agriculture, particularly non-cereal food availability, higher oil prices and exchange rate movements. As such, it was only appropriate to leave policy interest rates unchanged.

While the eight per cent inflation objective appears reasonably secure for January 2015, the balance of risk to the January 2016 target of six per cent is still uncertain and policy preparedness is necessary to contain these risks if they materialise.

New normal for inflation?

Some observers have raised a critical question as to whether the eight per cent target for January 2014 and six per cent for January 2016 reflects an attenuation of the resolve of the golden days of working towards a four per cent inflation rate. This criticism is unfair to the RBI and more particularly, to the Patel Committee. There could, conceivably, be one path which would undertake a sharp and sudden crushing of inflation, with significant dislocation or a more gradual reduction in inflation with little or no dislocation. So long as the RBI's policy is firmly committed to a glide path of reduction of inflation to a point where it does not create distortions and inequity, one should not find fault with the RBI.

The Patel Committee refers to an inflation rate of four per cent +/- 2 per cent inflation rate. One therefore expects (or rather hopes) that the RBI would be reluctant to drop policy interest rates prematurely. But the political economy of policy interest rates has to be taken into account and it remains to be seen as to how developments pan out.

Governor Rajan's stance on inflation

Governor Rajan, in a post-policy interview with journalists is reported to have said that: "If early next year, ... if we think inflation will hit 6 per cent before 2016 and stay that way , then we have room to cut rates even at this point itself, inflation has come down but is still above 6 per cent. It is not as if we have to touch 6 per cent."

While this will give grist to the speculation mills, it is also necessary to take note of Governor Rajan's statement that: "The problem in the last few fights against inflation has been that every time we look like succeeding, the clamour arises-oh, we have had high interest rates, why don't you cut interest rates. We do not want high interest rates for longer than we need to have but we don't want to keep fighting inflation every two years."

The view succinctly set out by Governor Rajan has been referred to at length, as economic agents with their own predilections will latch onto the statement that we do not have to wait for the six per cent inflation rate to cut inflation rates. The real message which should be taken from Governor Rajan is that he would not want to be fighting inflation again and again every two years. One should not take the stance that if Governor Rajan deems it fit to continue to hold rates up, it should not be treated as a negation of what he has said in August 2014.

Concern for depositors

Although depositors are the real owners of banks, they are treated as poor relatives who have little say in the power play of economic agents. Political economy forces are always aligned with the forces calling for lower interests for borrowers.

Strategy for depositors

Depositors must take the August 2014 policy as a reprieve. Hopefully, the RBI will be steadfast in its resolve not to drop policy interest rates prematurely. But the ground realities are that political economy forces may hold sway and policy interest rates could be reduced. Depositors will have to face the adverse effects. Depositors should minimise their Savings Bank balances to the extent possible, as they earn a large negative real rate of return. The obvious cartelisation of the savings bank interest rate by banks does not stir any reaction from the RBI or other regulators like the Competition Commission or the government. As regards term deposits, depositors should lock into the longer maturity 3-5 year deposits, as these rates are unlikely to rise in the near future.

Inflation indexed bonds

A revamped Retail Inflation Indexed Certificate, with important modifications relating to the real rate of interest, as also payment of quarterly interest was under consideration. We are now in the fifth month of the current financial year and the scheme should be made operational very quickly.

Please Note: This article was first published in The Freepress Journal on August 11, 2014. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


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