Will interest rates decrease further

This week’s article is a slight detour from our earlier articles. Reason for this is the announcement of the latest RBI monetary policy on 6^th August. I thought it very pertinent to discuss the same first given the current challenging times. In order to appreciate RBI’s policy, it is important to know the background and also understand some financial terms which I shall try to explain in simple terms.

Policy Rate

RBI has cumulatively reduced 250 basis points (100 basis points = 1%) i.e. a substantial 2.5% since February 2019. Supporting the recovery of the economy assumes an important role in how the RBI shapes its monetary policies. The RBI has been proactive and has infused the requisite stimulus needed. Also, the effect of the rate reduction is seen on the lending rates on the banks. The RBI in its press release has stated that bank lending rates on fresh rupee loans have declined by 91 bps (0.91%) during March-June 2020.

However, given the unprecedented crisis caused by Covid pandemic many especially the general public expected a further reduction in interest rates. However, our analysis is that RBI does not have much space on further reduction of the rates.

The reason for that is the possible emergence of the dreaded monster “INFLATION” which we shall explain below.

INFLATION

As all of us are aware, inflation is a rise in prices. Another definition of inflation is a lot of money chasing too few goods. Thus it is clear that the reduction of interest rates and an increase in the money supply may lead to high inflation. Our analysis is that RBI is not proceeding with interest rate cuts as RBI remains sceptical of the inflation targets being met. The supply chain disruption on account of COVID 19 persists and has implication on both food and non-food inflation.

The uncertainty pertaining to the spread of pandemic and length of economic weakness has only complicated the matter. In this regard, it is pertinent to note that RBI has set a target for one of the inflation indices i.e. the Consumer Price Index (CPI). The internal inflation target of CPI is 4% within a band of +/- of 2%. Unfortunately, this target of CPI is further obscured by the expected rise in food price due to floods in various parts of the country. Also, the cost-push pressures in the form of higher taxes on petroleum products, hike in telecom price and non-availability of raw material will have a further effect of inflation.

Another factor is volatility in financial markets and rising asset prices which also pose risks of higher inflation. However, on the positive front, a bumper rabi crop and a marginal increase in the minimum support price (MSP) are supportive of this benign inflation target.

Our analysis is taking into account all of these factors the headline inflation may remain elevated in Q2 and Q3 of FY 2020-21. Thus RBI will remain watchful of the incoming data and judiciously observe on how the outlook unravels in the coming quarters.

The space of further monetary policy action will be used judiciously and opportunistically. The reason for that is we are facing a situation similar to STAGFLATION (Growth of Economy may stagnate further and Inflation may go Higher)

In conclusion, we believe the interest rates may not be reduced further unless the economy starts showing major weakness from the current levels. Let us all wait and watch to see the entire picture unfold in these challenging but interesting times.

(I personally acknowledge and appreciate the professional inputs given by a CA Abhay Nair in writing this article)

Read the article in Malayalam