Retail inflation dips: why isn't RBI cutting borrowing rates?

  • Gaurav Choudhury, Hindustan Times, New Delhi
  • Updated: Dec 13, 2014 12:42 IST

Everybody seems to want the RBI governor to hit a six. But Raghuram Rajan is happy playing defensive strokes, because his main objective is to guard the wicket. Lest a wrong 'un uproots his stumps.

If you think this isn’t quite cricket, you need to understand the relationship between inflation and interest rates.

Shunning calls from industry and Parliamentarians to cut interest rates, Rajan has bluntly said his mission in the stately RBI headquarters in Mumbai’s Mint Street, is not attracting Facebook `likes’. And anyway, ever since his famed prediction about the impending global crisis of 2008, Rajan is known to call a spade a shovel.

With inflation plunging to multi-year lows, the average citizen, business leaders, economists and politicians all seem to be asking the same question: Why isn't Rajan cutting borrowing rates?

“I took a loan of Rs 54 lakh in 2006 to buy a house in Noida. I was comfortable with a monthly EMI of Rs 48,000 at that point in time. Now the EMI stands at Rs 64,000. It is hurting me badly,” said Sudhir Verma, an independent Delhi-based marketing consultant.

The central bank uses monetary tools to stymie demand and cool prices.

In times of weak growth and low prices, it is usual for RBI to cut interest rates to goad companies to invest, add capacities, hire more, and prompt people to spend on houses, cars and other goods.

Today, retail inflation is at a three-year low of 4.38%, wholesale inflation at a five-year low of 1.77%, and overall economic growth at just above 5%. The RBI, so the argument goes, should cut lending rates, which will lower EMIs, spur consumer purchases, cut companies’ borrowing costs and thus aid investment.

Rajan is probably wary about getting lulled into a comfort zone and playing a false shot, as low inflation could prove fleeting. He would rather wait, than be goaded into dropping his guard on price control. Chit chat from the fielders never bothered him anyway.

This is partly because of a statistical phenomenon called the “base effect”. Onion retailed at about Rs 80 a kg this time last year compared to about Rs 40 a kg now, showing a fall of about 100%.

There could be yet another reason: the rupee fell to a 9-month low of Rs 62.33 per dollar on Thursday, and could slide further if the US Federal Reserve, in a meeting next week, decides to raise interest rates from next year.

Higher yields could prompt foreign funds to move closer home to the US; the dollar outgo will hurt the rupee, unless rates here are high enough for foreign funds, and match the returns they could get in the US.

A weak rupee will fan inflation by raising prices of imported goods including oil, gadgets and mobile phones.

Costly loans may not be the only reason that holds back investment. If companies aren’t adding capacities, it may also be because of low demand for their goods — as people aren’t spending enough.

His unwavering focus to keep inflation firmly bottled up has evoked unusually caustic comments from politicians, who hit out at the Rajan’s hawkish stance, reflecting growing differences between Parliamentarians and the central bank.

Industry leaders too believe conditions could not be more benign for lowering loan rates.

“There could not have been a more favourable time for an interest rate cut with low energy prices, the currency stable and inflation falling. Rajan could have been a little more courageous,” a top business leader told HT requesting not to be identified.

Analysts said RBI is guided more by inflation-adjusted “real” interest rates. The repo rate—the rate at which RBI lends to banks—at 8% and retail inflation at 4.38% implies a real interest rate of about 4.5%. It could fall anyway once the inflation rate starts rising in the next few months.

“We believe the central bank will follow a framework of keeping positive real rates to the tune of about 1.5-2%. The key determinant of the magnitude of rate cuts will be where inflation settles on a sustainable basis,” Morgan Stanley, an investment bank, said in recent research report.

Finance minister Arun Jaitley said he agreed with the call for lower rates but added that the final decision was for the monetary authority, the RBI.

"In spite of inflation easing, interest rates have not been cut. There has been no spurt in manufacturing activity. I suppose Mr Jaitley is helpless in the face of an economist governor of the Reserve Bank of India," TMC MP Saugata Ray had said in Parliament. Congress leader Veerappa Moily echoed similar opinion.

Playing the role of The Wall never set the stadium on fire. But the governor is unperturbed — so far.

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