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Explained: Why the RBI refused to cut interest rates

RBI Monetary Policy December 2019: Even though the RBI expects economic growth to stay below 6% in the coming 12 months, inflation worries made it pause.

Explained: Why the RBI refused to cut interest rates Reserve Bank of India Governor Shaktikanta Das addressed the press after a monetary policy review in Mumbai on December 5, 2019. (Reuters Photo: Francis Mascarenhas)

RBI Monetary Policy December 2019: The Reserve Bank of India’s Monetary Policy Committee (MPC) surprised, shocked even, many observers of the Indian economy by announcing that it would not cut the repo rate as it announced its last monetary policy review for the current calendar year.

Repo rate is the rate at which India’s central bank loans money to the banking system. It is also the rate to which all new loans in the economy are benchmarked. A cut in the repo rate would have signalled a further reduction in the interest rate new borrowers — hoping to avail loans for homes and cars etc. — will be charged by the banking system.

In the first five bi-monthly policy reviews of 2020, the RBI had cut repo rate by 135 basis points. Hundred basis points make a full percentage point.

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Most economists and bankers expected the RBI to cut the repo rate by at least 25 bps. Many actually wanted a 50 bps cut in a bid to boost India’s sharply decelerating economic growth.

Yet, all six members of the MPC — three representing the RBI and three nominated by the government — unanimously voted in favour of maintaining the status quo and not cutting repo rate.

What was the challenge before the RBI?

When it comes to monetary policy, the RBI’s most important mandate is to maintain price stability. To this end, the RBI is required by law to maintain retail inflation — which is based on Consumer Price Index (CPI) — at the 4% level (with a band of variation of 2 percentage point).

But, another key concern for the RBI is the overall economic growth in the economy.


Since, more often than not, retail inflation and economic growth tend to rise and fall at the same time — because higher growth implies higher demand for goods and as such a spike in prices — the RBI’s work is simple.

However, at the current juncture in the Indian economy, economic growth has decelerated sharply even as inflation has sped up.

Retail inflation rose to a 16-month high in October and breached the RBI’s target level of 4% even as India’s GDP growth decelerated for the sixth consecutive quarter to just 4.5% in Q2 (July to September), which is a new six-year low.


So the challenge before the RBI was to balance the concerns of boosting growth while making sure that inflation does not spiral out of control.

So, what are the RBI’s forecast for economic growth and inflation?

The news is not good on either variable.

The RBI has dialled down the economic growth forecast for the current financial year by another full percentage point to 5%. The rapidity of deceleration in economic growth can be gauged by the fact that just between the past two policy review — that is 4 months — RBI has cut the growth forecast for the current financial from almost 7% to 5%.

What’s more, economic growth is expected to stay below 6% in the coming 12 months — that is till September 2020.

On inflation, the numbers have consistently gone up. From a retail inflation forecast of just 3.6% in the second half of the current financial year, the RBI has now raised the forecast to as high as 5.1%. However, in the first quarter of the next financial year, that is April to June, inflation s expected to moderate.


Why didn’t the RBI cut rates when growth is faltering?

There are several aspects to the RBI’s logic.

The RBI is obviously worried about the rise in inflation, which is the primary issue that the RBI is mandated to control. RBI Governor Shaktikanta Das reiterated this in the media interaction.


Secondly, the RBI has already cut repo rates by 135 bps. But only about 44 bps have been passed on to the consumers of new loans. The RBI believes that with more time, the monetary transmission will deepen. RBI Governor Shaktikanta Das said that the market already has surplus liquidity. In other words, he pointed to the fact that there is money in the market if one wants to borrow but credit off-take has been weak and it is unlikely to improve by another rate cut.

Thirdly, the RBI pointed towards the forthcoming Union Budget for fiscal efforts to boost growth.


If RBI is so bothered about inflation then why not raise rates?

Under normal circumstances, the RBI would have raise repo rates when faced with such high headline retail inflation. But the current circumstances are more complicated.

One, the reason for the rise in inflation is the spike in food prices, which are expected to be a transient factor. As agriculture recovers from the unexpected weather shocks such as unseasonal rains towards the end of the Kharif crop, food prices are expected to moderate and so is the headline inflation.

Two, the economic growth slowdown is an obvious worry for all policymakers. A hike in repo rate at this time will make matters considerably worse for the revival of economic growth.

What’s the upshot?

The Indian economy’s biggest worry is the growth slowdown, and in particular, the fall in consumer demand. Unless and until that improves, the economy will not be out of the woods. Inflation is a worry but the reasons for inflation are transient. It helps that crude oil prices are low and expected to stay low for some time otherwise the same food price inflation would have been more pronounced.

The RBI has already cut as much as it could in the current cycle and it is now waiting for these cuts to take effect. Typically, a rate cut takes at least a couple of quarters to show impact.

The ball is now in the government’s court. Can it cut tax rates — especially GST rates — and boost consumer demand?

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First published on: 05-12-2019 at 12:58:26 pm
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