Here’s the latest story being sold. Retail inflation has been high because food inflation has been high. In November, retail inflation was 5.5% whereas food inflation was 9%.
Core inflation, or the inflation after leaving out food items, fuel and light items, and petrol, diesel and other fuels for vehicles, and which forms a little over half of retail inflation, was 3.9%. To market participants, this means that inflation is under control because there is nothing that RBI can do to control food inflation.
Hence, it should cut rates to boost growth, which in the July to September quarter took more than an expected beating. This is something that Das seemed unwilling to do.
This is first-order thinking. But real economics is about thinking beyond that: about second-order effects, to start with. So, what’s not obvious here?
Market participants and corporates have an incentive to keep demanding lower rates. For companies, lower rates mean lower interest outflows on their existing borrowings and hence higher profits and possibly higher stock prices. They can also borrow more cheaply.
For market participants, lower rates mean that retail investors are incentivized to invest more in stocks in search of higher returns, leading to higher stock prices. They also manage more money and hence make more money. This happened after covid as interest rates fell.
Further, at lower rates, people are likely to borrow and spend more, which benefits listed corporates and can lead to higher stock prices. So it’s clear why market participants and corporates keep demanding lower rates. Of course, they don’t tell us this. Instead, they sell a story that RBI cannot control food inflation. Hence, it should cut rates.
Now, RBI knows that it cannot control food inflation. Also, while creating conditions for growth is important, there are other factors too. First, there is always the danger of sustained food inflation turning into generalized inflation. RBI can look to control this dynamic by controlling inflation in non-food items through higher interest rates.
Second, with more retail investors investing in stocks, the composition of bank deposits has changed and this has led to an increase in the asset-liability mismatches of commercial banks. This needs to be taken into account.
Third, for banks to charge lower loan rates, they need to pay lower rates on deposits. Interest on deposits is income for many households. Lower rates can lead to a fall in income for them and thus impact consumption. This tends to get ignored.
Fourth, the several cash transfer schemes launched by state governments are likely to fuel food inflation and in the process general inflation.
Fifth, RBI is currently facing a trilemma. A central bank cannot simultaneously achieve three objectives: Free international capital movement, a fixed exchange rate and an independent monetary policy. It can only choose two of these three goals.
Lately, after Donald Trump won the US presidential elections, the Indian rupee has been losing value against the US dollar. RBI has been trying to slow down this fall. It needs to do that because India imports more than it exports. A fall in the value of the rupee makes imports pricier and that feeds into inflation.
This is one recent reason why RBI has maintained a status quo on the policy rate front. Higher rates continue to incentivize foreign investors to keep investing in interest-paying bonds of various kinds issued in India, ensuring that US dollars flow into India, which in turn helps slow down the fall in the exchange value of the rupee.
Which is why, in order to ensure free movement of foreign capital and slow down the fall in the rupee’s value, RBI has given up some control on monetary policy by maintaining a status quo on the interest rate front. But then, this isn’t something you expect market participants to understand. It’s not a clear and crisp story.
Finally, market participants expect the new governor Sanjay Malhotra to cut rates. Several reasons have been offered. First, he comes directly from the ministry of finance (he was revenue secretary most recently) and thus understands what the economy needs. Second, analysts seem to expect Malhotra to adopt a dovish stance, which raises hopes for lower interest rates.
This is regular fluff that is said on such occasions. Malhotra is not the first person working for the finance ministry who has moved to RBI. There were others before him and they did not always do what the ministry perhaps expected them to.
For the finance ministry, economic growth possibly remains the most important factor while thinking about the country’s monetary policy. RBI has to take other factors into account as well.
Now, this does not mean that Malhotra should not cut rates. Not at all. But RBI, while deciding on monetary policy, needs to take various factors into account. Hopefully, Malhotra will do that as he opens his innings.
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