Inflation vs Interest

The Reserve Bank of India kept has key repo interest rates unchanged as they have forecasted that widely inflation would accelerate beyond its 4% target in the current and..

The Reserve Bank of India kept has key repo interest rates unchanged as they have forecasted that widely inflation would accelerate beyond its 4% target in the current and the next fiscal year.  

Background

Inflation and interest rates are linked. Inflation refres to the rate at which prices for gods and services rises. Interest rates are determined in India by the Reserve Bank of India. The repo or the key policy is the rate at which the RBI lends funds to the banks. The real interest rate is calculated by deducting inflation from the repo rate.

In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save as returns from savings are higher. With less disposable income to spend as a result of the increase in savings , the economy slows and inflation decreases.

Inflaion is also closely related to unemployemnt. The Philip Curve relates the inverse relationship between the two. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, this concept has been challenged emeprically due to the occurrence of stagflation in the 1970`s when there were high levels of both inflation and unemployment.

Analysis

The Taylor rule – an interest –rate forecasting model devised by economist John Taylor – gives policy rates prescriptions after taking into account the difference between targetted and actual inflation and potential and actual output growth. It will give a higher prescribed rate if inflation is higher than targetted inflation and output growth is above potential output growth.

The Taylor rule – implied policy rate for India has steadily risen in recent months, given the rise in inflation, as it says that the appropriate short-term interest rate for India now slightly exceeds current policy rate of 6.5% under different assumptions.

RBI lowered the economic growth forecast for the fiscal year to 6.7% from 7.3% earlier, arguing that the June quarter slump to a three-year low may be transient, and raised inflation forecasts citing pressures from possible fiscal slippages, state government staff salary increases and spike in oil and food prices. The economic growth forecast as a whole is consistent with an acceleration in the second half to 7.1% in third quarter and 7.7% in the fourth, it said. RBI cut the statutory liquidity.

But the impact of the measure will be neutralised as the regulatory need to keep such bonds under a different category comes into force. The six-member Monetary Policy Committee (MPC) headed by RBI governor Urjit Patel voted five to one in favour of holding the repo rate, at which RBI lends to banks, at 6%. SLR was cut to 19.5% from 20% with effect from October 14. All other rates remain the same.

“Basically, we have to wait and watch on how the evolution of inflation takes place over the next six to seven months in terms of what happens and our projections,’’ said Patel. “But as you know, inflation has been volatile within two months. It increased by 2 percentage points, so we will see what happens,” He added.

Although the RBI acknowledged that economic growth rate was disappointing and lowered it for the second half of the fiscal year, it said the effects of the implementation of the goods and services tax (GST) may be transient and the noise around it may be unwarranted.

The recent loss of growth momentum seems to have energised quite a lively debate,” said deputy governor Viral Acharya. “It is, however, too early in my view and real-time activity indicators do not yet paint a clear picture to be able to separate the transient component of this one quarter loss of momentum from the gradual decline in overall growth that has taken hold since the first quarter fiscal 2016-17.’’ In fiscal 2019, economic growth as measured by the gross value added, could climb to 7.

Inflation is projected to reach 4.2-4.6% by March, up from 3.5-4.5% projected earlier. For fiscal 2019, price pressures could worsen with inflation projected to touch a high of 4.9% before cooling off to 4.5% by March 2019. There could be an additional 100 basis point impact if state governments also implement salary increases. But that could change, depending on circumstances.

There might be some reversals of commodity prices, which is a possibility,” said Patel. “Food inflation continues to be kept under control, so it is equally wrong to pre-judge either way how these things will evolve. What we have done is lay out the risks which could materialise with varying probability.”

Assessment

Our assessment is that good policy is a process and not a state of being. For India, a higher trajectory of growth is a must. For this, we need smart and positive cues. What is perhaps most discomforting is the recent report by 200 top companies  that they had seen a reduction in employment in the last few years , felt that  the disparity between the rich and poor had widened and more that the distribution of wealth had not reached all sections of the society. This is not a sustainable for a country with a demographic quotient like India. We feel that the real interest rate currently  in India  is  one of the middle values among a set of 26 major economies. For an economy like India, interest rates must be indexed 2 percent higher than the inflation rate.

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