High real interest rate, low inflation add to RBI dilemma; will it cut monetary policy rate? Expert take

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New Delhi | Updated: January 17, 2019 5:14:27 PM

The falling retail inflation on one hand and unchanged interest rate on the other, raise a potent question whether the real interest rate in India is too high to revive stagnated investment and thus boost growth.

The falling retail inflation on one hand and unchanged interest rate on the other, raise a potent question whether the real interest rate in India is too high to revive stagnated investment and thus boost growth. Consumer Price Index (CPI) hit an 18-month low at 2.19 per cent in December 2018 and wholesale price inflation touched an eight-month low at 3.80 per cent, due to lower food and energy prices. This has widened the gap between the nominal interest rate and inflation.

The real interest rate, which reflects the actual cost of borrowing has a significant bearing on investment decisions. According to a working paper published by the RBI, a one percentage point increase in the real lending rate reduces the real investment rate in the range of 0.3 to 0.4 percentage points.

The issue is of immense importance in the light of rising interest rate in developed economies after years of near-zero interest rate. The real interest rate in India is 4.3 per cent which is high compared to other emerging economies in Asia such as China, Bangladesh, South Korea and so on.

Given the actual inflation prints continue to be lower than RBI forecast, the RBI is likely to change its stance to neutral from calibrated tightening in Feruary 2019, Sameer Narang, Chief Economist, Bank of Baroda, said to Financial Express Online. “The continuous undershoot of inflation, coupled with lower global oil prices and muted global growth outlook, gives RBI to change its stance to begin with before it cuts rates,” Sameer Narang said.

However, there may be concerns of inflation shooting back up, preventing RBI from being too dovish. In the future, as forecasted by the ICICI Bank, inflation is expected to rise with a possible reversal in food prices and higher government spending due to upcoming general elections.

“RBI targets inflation and as long as core inflation is high at 5.5-6 per cent, it will not lower the interest rate which is the only factor that affects growth,” Madan Sabnavis, Chief Economist, CARE Ratings, said to Financial Express Online. He also pointed out towards the weak demand owing to low farmer income and subdued private investments and suggested the resolution of NPA problem with utmost priority.

Sujan Hajra, Chief Economist, Anand Rathi, also agrees that the inflation will not be this low for long. He said that he expects a total fall of 75 bps through the year 2019, expecting a change in the stance of the central bank from calibrated tightening to neutral. He also expects the RBI to continue with its open market operations to maintain the liquidity flow in the economy.

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