Given both low inflation and subdued economic conditions, most analysts are looking at RBI cutting repo rates by 25-50bps during the year, but this is expected after the government makes its fiscal stance clear. If it is expansionary, RBI will not cut rates as the increased spending—due to the Pay Commission and UDAY—will be inflationary. Governor Rajan’s recent speech, where he talked about how no one could fool the bond markets is seen as an indication of the central bank’s mind. Waiting to see the centre’s budget numbers, however, is irrelevant. In the absence of private investment picking up, not hiking government spending could result in lower growth and, eventually, a higher fiscal deficit than originally budgeted for. Nor, with the kind of excess capacity there is, can a one-way relationship be posited between fiscal deficits and inflation.
On the other hand, since the last monetary policy review, crude oil prices have further softened and, more important, the global economic situation has only got worse—and the US which looked like it was growing steadily has seen Q4 growth plummet from 2% in Q3 to 0.7%. Even if you don’t factor in a China recession, there can be little doubt that the global deflationary pressures which contributed to India’s inflation coming under control have only got worse. Also, with the base effect —CPI inflation started falling from 7.4% in July last year to 3.3% in November—now over, the rise in inflation is likely to be tempered over the next few months, allowing RBI to comfortably meet its 6% target for January 2016.
Also, one of the major reasons given by RBI for moving to CPI-based inflation targeting—and to keep a corridor between the repo and CPI—has been the need to keep a positive real rate of interest so as to stimulate savings. Savings, however, are not as much a function of interest rates as they are of income growth—all that interest rates do is to guide where the savings are invested. The latest GDP estimates confirm this. With GDP growth slowing, overall savings levels are flat at 33% of GDP—this is despite CPI collapsing from 9.5% in FY14 to 5.9% in FY15—and, within this, household savings are down from 20.9% to 19.1%; higher real interest rates during this period have resulted in a larger share of savings being directed towards financial assets. In other words, the central bank’s high interest rate policy is unlikely to stimulate savings—a rate cut, on the other hand, can stimulate the economy and, as a result, also give a push to savings.