T K Arun
The desired response from the RBI in an environment of falling inflation and a declining dollar index is to slash rates, not hold them steady
The RBI’s interest rate action is a bit like duck feet underwater. What is visible on the surface belies the activity unseen below the water. The way inflation is coming down, there is little to cheer about the RBI keeping its policy rate unchanged. The desired response from the RBI in an environment of falling inflation and a declining dollar index is to slash rates, not hold them steady.
The RBI’s repo rate went positive in real terms in November 2022, turned negative for a month in January, when the rate of inflation went higher than the repo rate and has steadily climbed higher into the positive region, now amounting to 2.25 percent, after the May retail inflation figure came in at 4.25 percent
The real rate of interest is, of course, the difference between the rate of interest you pay on your loan and the rate of inflation. Does the real rate of interest matter? After all, people pay their equated monthly instalments (EMI) or interest on bank loans based on the nominal rate of interest. The easiest way to appreciate the importance of the real rate of interest is to look at interest rates from the point of view of a saver, who depends entirely on the income earned on deposits for monthly household expenditure.
Inflation Impact
When prices go up, this income would purchase fewer goods and services than in the past. Suppose the annual interest income earned is Rs 1,00,000, and the annual expenditure is Rs 90,000. The saver has a little something left over for indulgences after meeting his expenses. Suppose the rate of inflation 11.1 percent. Then income would be equal to expenditure, and there would be nothing left over. Suppose the rate of inflation were 12 percent and not 11.1 percent, the same basket of goods and services purchased for Rs 90,000 would now cost Rs 100,080.
With the same nominal rate of interest on deposits, the saver would have to crimp his expenditure a wee bit. Suppose the rate of inflation were 15 percent, what could be purchased earlier for Rs 90,000 would now require an outlay of Rs 103,500.
The only way the saver’s consumption would be protected would be if the interest rate on the deposits floated, to neutralise inflation or even give a tiny margin over the rate of inflation.
When the rate of inflation is higher than the rate of interest, the lender loses out, like the depositor in our example, and the borrower gains. The reverse happens when the rate of inflation is lower than the rate of interest. The borrower has to shell out on interest payments a larger proportion of her inflation-adjusted income, that is, real income, than when the real rate of interest is zero or negative.
From the perspective of fuelling growth, lower real rates, whether these are negative or mildly positive, are better than high real rates. When the nominal rate remains unchanged when the rate of inflation dips, the real rate goes up. When the RBI keeps the repo rate, which forms the basis for bank lending rates, unchanged even as inflation keeps falling, it effectively raises rates.
There is one consideration other than domestic inflation that could weigh on central bank rate-setters. This is the interest rate differential with the US economy. If the US central bank, the Fed, keeps raising rates even as others hold steady or raise their policy rates by a lower extent, the dollar would become stronger. Weaker domestic currencies could feed inflation, via imports denominated in dollars.
Dollar Strength
But there are things other than the interest rate differential that drives exchange rates. Capital flows induced by fluctuations in economic confidence or perceived opportunities drive exchange rates apart from the flows that seek to take advantage of interest rate differentials.
There is a measure of the dollar’s strength vis-à-vis six other currencies — the euro, the pound, the yen, the Canadian dollar, the Swiss franc and the Swedish kroner — called the dollar index. Over the last year, it had touched a peak of 114, and has been trending down of late, and now stands at a little over 103. What this means is that the RBI need not worry about keeping real interest rates in India high on the consideration of averting undue depreciation of the rupee vis-à-vis the dollar.
The global growth scenario is not one of robust demand for energy and commodities driving up inflation. Oil prices have been slackening, forcing Saudi Arabia to even announce a unilateral production cut. The German economy is in technical recession, having registered two consecutive quarters of negative growth.
The Euro Zone stumbles in step. The US economy has been resisting the Fed’s best efforts to drive it to zero growth, so as to stamp out inflation, but still growth has slowed down. The Chinese economy is still licking its self-inflicted wounds and its growth has slowed down, which is the prime reason for depressed oil prices.
Thanks to Russia’s rise as the largest source of oil for India, and not having to pay for the oil in dollars, there is considerable leeway on the exchange rate, even if the current account deficit had not been narrowing, on account of lower imports overall.
So, there is no pressure on the central bank to keep rates high. It should prioritise domestic growth and slash its policy rates ASAP.
The article was first published in Money Control as Policy inaction by the RBI is hiking real rates, growth calls for lower rates on June 14, 2023.
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