By Suganya Balakumar
The repo rate is one of the monetary policy instruments of the Reserve Bank of India (RBI). The RBI performs a rate cut when it wants the liquidity in the economy to increase; commercial banks then pass on the rate cut to the customers. This increases the cost of goods and services, and thereby inflation. Using this chain of influence, the RBI manipulates the repo rate to control inflation.
On 2nd August 2017, the RBI went for a rate cut of 25 basis points (from 6.25% to 6.00%); a six-and-a-half year low. This was an expected move from the RBI due to falling prices and low forecasts of inflation in the economy. The forecasts of inflation were 2%-3.5% for April-September. However, the inflation rate was only 1.54% in June, which later increased to 2.36% in July due to the increasing vegetable prices the impact of the Seventh Pay Commission, and the GST rollout.
A prolonged pause
Following the Monetary Policy Committee (MPC) meeting on 16th August 2017, the Japanese financial services major Nomura reported that “Economic growth and inflation are expected to trend higher in the next 6-12 months and the Reserve Bank is likely to stay on a prolonged pause”.
The report suggested that the RBI went for a rate cut earlier this month due to low inflation and growth concerns. Most members of the MPC had voted for the rate cut, following which they have planned for a prolonged pause expecting a higher inflationary trajectory. The report mentioned that “In view of the recent data on inflation and the neutral bias of most MPC members, we expect the RBI to stay on hold in October likely with a 5-1 vote.” The report expects that the Goods and Services Tax (GST) related activity disruption would also wane, and the growth and inflation trend would be higher in the next 6-12 months.
Negative output gap
One of the MPC members Dr Ravindra H. Dholakia, Professor of Economics at IIM Ahmedabad, mentioned that the core inflation is on a declining path with minor spikes and would settle at 3.1-3.5% by March-April 2018. The headline inflation will also converge around that. He also warned about the stagnant capacity utilisation, which has been below 75% for a long time and would further worsen the negative output gap.
The output gap is the difference between potential output and actual output. A negative output gap explains that the economy is functioning below capacity. In the MPC June review meet Dr Dholakia had voted for a 50 basis point cut, mentioning that the interest rates had scope to fall further.
Future rate cut?
Several factors continue to contribute to the possibility of a rate cut in the future. Lower interest rates would encourage companies to borrow more, and increase the liquidity in the economy. Firstly, inflation has hit a record low in the recent months. 1.54% inflation rate in June was the lowest in five years. Secondly, our GDP growth has slowed down to 6.1% in March quarter from 7% in the preceding quarter, mainly due to demonetization and low credit growth to companies. The GDP growth rate is expected to be 6.6% in the June quarter. Thirdly, banks do not completely pass on the rate cut to the customers. This was observed in October 2016 when the banks were reluctant to pass on the rate cut. This shows that the RBI can cut rates without hurting the savers. Lastly, based on the Taylor rule the rates can be further reduced. The Taylor rule is a yardstick which measures the appropriate interest rate in the economy. It estimates the desired rate given the output and inflation levels in the economy.
Therefore, the expectations are that the economy would inch towards a 4% inflation rate, and there would be no changes in the monetary policy stance of the RBI in the near future, but there is still scope for the RBI to cut the policy rate further.
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