RBI paused on rates in Feb on fears remonetisation will fan inflation | business-news | Hindustan Times
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RBI paused on rates in Feb on fears remonetisation will fan inflation

Contrary to market expectations of a 25 bps rate cut, the Reserve Bank of India in its monetary policy review earlier this month left the rates unchanged over apprehension that rapid remonetisation would spur demand and fan inflation.

business Updated: Feb 22, 2017 19:06 IST
Raj Kumar Ray
A man walks past the RBI office in Kolkata.
A man walks past the RBI office in Kolkata.(REUTERS File)

Contrary to market expectations of a 25 bps rate cut, the Reserve Bank of India in its monetary policy review earlier this month left the rates unchanged over apprehension that rapid remonetisation would spur demand and fan inflation.

There was disappointment over RBI rate pause as January CPI inflation came at 5-year low of 3.2%. Since 2015, RBI slashed policy lending rate by 175 bps to 6-year low of 6.25% and has little room to lower rates further. But the actual reason for the rate pause is now out in public.

According to the minutes of the RBI’s Monetary Policy Committee’s meeting during February 7-8, most of the MPC members including RBI Governor Urjit Patel felt that economic activity is expected to pick up at the end of current fiscal with remonetisation.

The potential threat of rising prices of crude oil and food items also played on the minds of the MPC members.

“With the remonetisation of the economy taking place at an accelerated pace over the last two months, economic activity is expected to pick up from the latter part of Q4 of 2016-17. Discretionary consumer demand, which got impacted in the immediate aftermath of demonetisation, is expected to bounce back,” Patel said in his statement at the MPC.

Patel said the macroeconomic conditions remains “clouded”.

On the inflation outlook, Patel said transient factors, including anecdotal evidence on fire sales of perishables, have discoloured an objective assessment of inflation pressures in recent months.

“Past experience suggests that the rebound in vegetable prices could be sharper than normal. Importantly, non-food non-fuel inflation has remained sticky, notwithstanding the transitory impact of demonetisation on consumption demand.”

He added that crude oil and commodity prices (including for food) have firmed up globally, thereby potentially raising risks to the headline inflation.

Patel’s deputy Viral Acharya admitted that it was a “tough decision” to make on interest rates given the impact of remonetisation. “Rapid remonetisation implies likely swift reversal of the aggregate demand loss and the significant transmission to borrowers of easy funding conditions at banks suggests unlikely further transmission of a rate cut by banks.” he said.

RBI executive director Michael Debabrata Patra warned the reflationary effects of remonetisation are likely being “underestimated”. With transactions requirement of currency amply met, he said “the positive shock that is travelling through the economy can be expected to fuel inflation well before the more sluggishly moving activity and demand respond.”

Ravindra H Dholakia, a professor of Indian Institute of Management, Ahmedabad also flagged the concern that as the transitory impact of demonetisation recedes and remonetisation sets in, the banks’ MCLRs are likely to increase marginally.

“Moreover, under the current global environment, the real neutral rate of interest in India seems to be higher than the one for most of the developed countries. However, their future policy direction indicates rapid strengthening of the rates.”

Delhi School of Economics director Pami Dua noted that while the transitory effects of demonetisation on inflation and output gap have yet to be fully assessed, the ratio of currency in circulation to GDP is on the rise, suggesting that remonetisation is progressing well.