No Proof Required – Repo rate cut in 2015: 200 bps

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Updated: January 23, 2015 1:36:15 AM

Most rate cut forecasts are out of sync with the underlying trend of inflation (and growth) in India or the world

RBI, over the last several years, has changed the goalposts of monetary policy more often than the batting collapses of the Indian cricket team. Remember protein inflation as a cause of high CPI inflation in India? Or the stubborn refusal of RBI, and its research experts, to acknowledge the role played by minimum support prices (MSP) in generating high food, and overall, inflation in India? In four articles on inflation by RBI executive director and economist Deepak Mohanty, none contain any documentation, or discussion of causal linkage, on the (now) widely-accepted contribution of MSP to inflation. Deputy Governor Urjit Patel’s voluminous report on the need for a new monetary framework (read inflation-targeting) also does not mention MSP as a cause but does discuss the important (sic) role played by MGNREGA in generating wage and therefore, overall inflation.

For the last year and a half, we have been fed the mantra of high inflation expectations, low base effect, and the prospect of inflation targeting as possible determinants of theoretical CPI inflation. Coincident with this discussion, actual CPI inflation has halved from the “low base” December 2013 figure of 9.9% to 5% in December 2014. Given this reality, RBI cut the repo rate to 7.75% on January 15, 2015. Given the long wait for this cut, expectations are high, and varied, about the magnitude of repo rate cuts expected in 2015. All economic experts expect at least one more rate cut of 25 basis points (bp), and some even an additional 75 bp. The central tendency of experts’ recommendation is for an additional 50 basis points. Anticipating the conclusion of my research and reasoning (documented below), I believe the additional repo rate cuts needed, and hopefully delivered, are more than thrice that anticipated by the experts.

How is this result derived? By following the RBI logic to its inevitable end. In an interview with Prannoy Roy, NDTV, December 27, 2014, Governor Raghuram Rajan set a new goalpost for the tracking of monetary policy in India. In an answer to Roy’s question “Isn’t it [the case] that real interest rates are too high?”, Rajan responded, “Depends on how you measure real interest rates. The CPI today is about 6-6.5% … the real interest rate is 1.5% … It is about what it is in the rest of the world—it is not higher than the rest of the world; this is where the world is.”

This goal post of real rates in India comparable to the rest of the world seems eminently sensible in this globalised, hyper-competitive world.

And the goal post does not suffer from the wooliness of inflation expectations nor from the ambiguity of inflation targeting. This new metric says that whatever the model of inflation one (or RBI or market experts) might have, we are expected to be guided by what the central banks in the rest of the world are doing. India is not unique, no matter how much Hindutva experts might claim it is. Red blood also flows through our veins, and if government policy is not interventionist, then Indian inflation is likely to follow the path of world inflation, particularly the path of inflation in emerging economies.

The table documents the average inflation, overnight interest rate (repo), and real interest rate for different classifications of countries in the world. These classifications are: a) 125 countries in the different regions of the world; and b) 39 “representative” economies in the world as reported by The Economist in their table ‘Economic and Financial Indicators’. The following three conclusions emerge from this large sample of countries.

First: The thirty one countries of sub-Saharan Africa and five countries of South Asia are in a class by themselves in terms of the real repo rate. Both regions report real repo rates in the neighborhood of 2.8% (Indian real rate, after the repo cut, is 2.75% with inflation at 5% and repo rate at 7.75%). Is it correct to infer that Indian macro-economy parameters, and policy, should be similar to sub-Saharan Africa or Pakistan and Sri Lanka?

Second: Average real rate in the world (125 countries) is 1.4%. Excluding sub-Saharan Africa and South Asia, the average drops to 0.8%
(89 countries).


Third: The Economist documents every week financial indicators for 42 major economies. If the three “problematic” economies of Argentina, Venezuela and Ukraine are excluded, then the average representative real repo rate is only 0.3%. Excluding the developed countries from this average, the “representative” real repo rate increases to 0.8%.

A conservative conclusion for the comparable real repo rate for India is 1%. In order to determine the desired or comparable nominal repo rate, one needs an estimate of future inflation in India. The IMF estimate of mean CPI inflation for the comparable economies (excluding developed economies) is slightly less than 4% for each of the next three years. This estimate was made in September 2014, well before the decline in oil prices. Given that extraordinary food inflation is out of the Indian economy, it is reasonable to assume that the upper bound on average Indian inflation is less than 4.5%. This means that the comparable nominal repo rate in India is 5.5%, or that 225 basis points of repo rate cuts are what one should expect in 2015—if Governor Rajan does not change the goal post of comparable economies, that is!

The author is chairman, Oxus Investments, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla

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