The Reserve Bank of India(RBI) governor Raghuram Rajan presented the first monetary policy for this financial year, yesterday. He kept the repo rate at 7.5%, after having cut it by 25 basis points(one basis point is one hundredth of a percentage) each in January and March, earlier this year. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
Rajan further said that “going forward, the accommodative stance of monetary policy will be maintained.” This meant that the RBI would continue to bring down the repo rate subject to a few factors.
First, Rajan said that the banks had not passed on the earlier cuts in the repo rate to the end consumers by cutting their base rates or the minimum interest rate a bank charges its customers. Without this happening there is no point in the RBI cutting the repo rate. (In a column earlier this month I had explained why banks are not cutting their base rates. You can read it here).
Secondly Rajan said that “ developments in sectoral prices, especially those of food, will be monitored, as will the effects of recent weather disturbances and the likely strength of the monsoon.” The northern part of the country has seen unseasonal rains and that has led to rabi cop being damaged. This is expected to push food prices up. Governor Rajan wants to monitor this for a while and see how it pans out, before deciding to cut the repo rate further.
Third, the RBI is watching what the government is doing on the policy front to “ to unclog the supply response so as to make available key inputs such as power and land.” And fourth, the Rajan led RBI is watching “for signs of normalisation of the US monetary policy”. This essentially means that the RBI is closely observing as to when the Federal Reserve of the United States, will start raising interest rates in the United States.
Depending on how these factors play out, the RBI will decide if and when to cut the repo rate further. But the question is how much room does the RBI have to cut the repo rate any further? Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.
The current repo rate at which the RBI lends stands at 7.5%. In the monetary policy statement released yesterday RBI said: “The Reserve Bank will stay focussed on ensuring that the economy disinflates gradually and durably, with CPI inflation targeted at 6 per cent by January 2016.”
If we consider the rate of inflation of 6% and add a real rate of interest of 1.75%(the average of 1.5% and 2%) to it, we get 7.75%. The current repo rate is at 7.5%, which is 25 basis points lower than 7.75%.
What if, we consider the latest rate of inflation as measured by the consumer price index? For the month of February 2015, the inflation stood at 5.4%. If we add 1.75% to it, we get 7.15%, which is lower than the prevailing repo rate of 7.5%. If we add 1.5% to the prevailing rate of inflation, we get 6.9%, which is sixty basis points lower than the prevailing repo rate of 7.5%.
What both these calculations clearly tell us is that there is not much scope for the RBI to cut the repo rate further. At best it can cut the repo rate by another 50 basis points. This is assuming that Rajan maintains his previous stance of maintaining a real interest rate level of 1.5-2%.
As of now there is no evidence to the contrary. As Rajan had said in September 2014: “Have we artificially kept the real rate of interest somehow below what should be the appropriate natural rate of interest today and created bad investment that is not the most appropriate for the economy?”
This is a very important statement and needs to be dealt with in some detail. Look at the accompanying chart.
The government of India between 2007-2008 and 2013-2014 was able raise money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt(i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008.
And if the government could raise money at a rate of interest below the rate of inflation, banks couldn’t have been far behind. Hence, the interest offered on fixed deposits by banks and other forms of fixed income investments was also lower than the rate of inflation, between 2007-2008 and 2013-2014.
This essentially ensured that household financial savings fell from 12% of the GDP in 2009-2010 to 7.2% of the GDP in 2013-2014. As the rate of interest on bank fixed deposits was lower than the rate of inflation, people moved their money into real estate and gold. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
If the household financial savings rate has to be rebuilt, the rate of interest on offer to depositors has to be significantly greater than the rate of inflation. Given this, a real rate of interest of 1.5-2% that Rajan has talked about makes immense sense, if household financial savings need to be rebuilt all over again.
And if a real interest rate of 1.5-2% has to be maintained then the RBI doesn’t have much scope to cut the repo rate further—around 50 basis points more.
The column originally appeared on The Daily Reckoning on April 8, 2015