Why RBI is unlikely to cut interest rates later this month

RBI-Logo_8Vivek Kaul  
The business lobbyists want the Reserve Bank of India (RBI) to cut interest rates, now that the inflation for December 2013 has come down. “The easing of inflation at a time when industrial growth continues to be in the red should induce RBI to review its monetary policy stance and cut policy rates to rejuvenate growth, which has been hit by high interest costs, flagging investments and subdued demand,” Chandrajit Banerjee, the director general of CII said. Similar statements were made by other business lobbies as well.
There are multiple issues that need to be discussed here. Lets start with the inflation. The consumer price inflation(CPI) fell to 9.87% from 11.16% in November 2013. The wholesale price inflation(WPI) fell to 6.16% from 7.52% in November 2013.
A major reason behind the fall in inflation is the fall in vegetable prices. As per the CPI index, vegetable prices in the month of December 2013 fell by 18.4% in comparison to November 2013. In case of the WPI, the fall was greater at 29.7%. Onion prices fell dramatically by 42.4%.
Nevertheless, the prices of a lot of other food items continue to go up. As per the CPI index, prices of egg, fish and meat have gone up by 12.6% in the last one year. The price of milk products has gone up 9.87%. Cereal prices have gone up by 12.1%. Interestingly, the prices of these food items has gone up in December 2013 in comparison to November 2013. In fact, as per the WPI index the price of rice has gone up by 13.6% in the last one year.
If one looks at the overall category of food products, the prices declined by 0.6%(as per the WPI index) and 2.4%(as per the CPI index) between November and December 2013. Given this overall food prices continue to remain high. Also, if one takes the food and fuel prices out of the equation, the core consumer price inflation (CPI) in December 2013 was at 8%.
It is widely believed now that Raghuram Rajan, the governor of the RBI, is looking more at the CPI number while making policy decisions. 
As he had said in a statement dated September 20, 2013 “What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence.”
Despite vegetable prices falling, the CPI number continues to remain on the higher side. If Rajan and the RBI continue to focus on the CPI number, it is unlikely that they will cut the repo rate any time soon. Repo rate is the rate at which the RBI lends to banks.
Even on the WPI front things don’t look too optimistic. Economists expect vegetable prices to continue to fall. But even with that they expect inflation to start rising again given that the prices of food items like rice are rising.
As Sonal Varma of Nomura Securities put it in a research note dated January 15, 2014, “Going forward, the correction in vegetable prices is still incomplete and should continue. However, with prices of other food items rising (such as rice) and base effects turning adverse, the expected fall in WPI in January-February should reverse again after March.”
As far as the industry lobbies are concerned they want the RBI to cut interest rates in order to revive industrial growth. The index of industrial production (IIP), a measure of industrial activity in the country, fell by 2.1% during the month of November 2013. The low industrial growth is also reflected in manufacturing inflation, which forms around 65% of the WPI index, and grew by a minuscule 2.6% in December 2013, in comparison to December 2012. In December 2012, the manufacturing inflation was at 5.04%.
What these low numbers tell us is the lack of consumer demand. People have been handling double digit consumer price inflation over the last few years. At the same time their incomes haven’t been able to keep pace with the rate of inflation. Food inflation has been been particularly high. A higher inflation also leads to the regular expenditure of people, as a proportion of income going up. Given this, they have had to cut down on expenditure on non essential items like consumer durables, cars etc, in order to ensure that they have enough money in their pockets to pay for food and other essentials.
This is reflected in the index of industrial production when seen from the use based point of view. The index number of consumer durables fell by 21.5% in comparison to November 2012. The index number of consumer goods, which has the highest weightage in the index, fell by 8.7%, in comparison to the same period last year. When the demand for goods is falling, it is but natural that there production will fall as well.
Hence, high consumer price inflation has been killing consumer demand. There is not much the RBI can do to control it, given that a major part of it is driven by a rise in food prices. At the same time, it won’t want to take the risk cutting interest rates, hopefully pushing up consumer demand and manufacturing inflation in the process. This will push up inflation further, and in the process build in more inflationary expectations into the system.
Also, it is worth remembering that the repo rate is at best an indicative rate. Even if the RBI were to cut the repo rate, it remains up to the banks whether they are in a position to pass on the rate cut to their consumers. The loan to deposit ratio of Indian banks as on December 27, 2013, stood at 75.2%. This means that banks have given out loans worth Rs 75 for every Rs 100 they had raised as deposits.
This ratio is on the higher side given that banks need to maintain a statutory liquidity ratio of 23% i.e. for every Rs 100 raised as a deposit they need to buy government bonds worth Rs 23. They also need to maintain a cash reserve ratio of 4% i.e. for every Rs 100 raised as a deposit they need to maintain Rs 4 with the RBI. Once this is factored in, the credit deposit ratio should not go beyond 73%. What this tells us is that banks have been borrowing from other sources at higher interest rates (in comparison to what they pay for deposits) to give out loans. In this scenario, the ability of banks to cut interest rates is rather limited.
Given these reasons, it is unlikely that the RBI will cut interest rates when it meets later this month on January 28, for the third-quarter review of monetary policy.
The article originally appeared on www.firstpost.com on January 17,2014

(Vivek Kaul is a writer. He tweets @kaul_vivek)