50 bps rate cut by RBI? Guv may go for jugular over inflation spiral

New Delhi | Updated: November 17, 2014 10:20:35 PM

We however maintain that Raghuram Rajan-led RBI may go for the jugular in a decisive manner...

If Raghuram Rajan's RBI leaves the rates unchanged in the coming policy review, the real rates would reach as high as 3.5%. (Reuters)If Raghuram Rajan’s RBI leaves the rates unchanged in the coming policy review, the real rates would reach as high as 3.5%. (Reuters)

The decline in wholesale price index (WPI) inflation to 1.77% (SBI:1.65%) for Oct’14 will raise the clamor for a rate cut. We however maintain that Governor Raghuram Rajan-led  RBI may go for the jugular in a decisive manner (50 basis point or so), but only after it is convinced that CPI downward trajectory is sustained and inflationary expectations are anchored decisively lower. Read Full Report

This may happen materially only in Q1FY16. However, in an inflation targeting framework, with the Government having the goal independence (and RBI: instrument independence) is likely to set a CPI target more than 4% and this may then hasten the RBI action. We expect the Government may set the CPI target around 5% or so, with deviation of around 2% on either side.


The logic of such actually follows from Patel Committee recommendations. The report points out that the level of CPI-combined inflation above which it is inimically harmful to growth is 6.2%.

If we take this as the threshold rate of inflation and juxtapose this with a 4% CPI target, it implies that the recommendations may have a built-in bias of being deflationary. By this logic, the band could be built around a mean of 5% with the deviations centred around such a mean.
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Meanwhile, after hovering in the negative territory for nearly 21-months, the real interest rate is now floating in the positive zone. If RBI leaves the rates unchanged in the coming policy review, the real rates would reach as high as 3.5% during Nov’14 by taking CPI as proxy and 7.2% if WPI is taken as proxy (for 1Y-3Y bucket). Interestingly it will led to a situation, where real interest rates will be higher than nominal interest rates for most banks in the deposit category of less than 1 year (up to 90 days). This is way above the 0.5% (CPI) and 1.5% (WPI) real rate prevailing on a cross cyclical basis in India.

By Dr. Soumya Kanti Ghosh, Chief Economic Adviser & GM, Economic Research Department, SBI.

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