Need to bring repo rate in line with inflation

April 29, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

For nearly three years now, the Reserve Bank of India (RBI) monetary policy has had a single target. The presumption is that only when inflation is below the tolerance limit can the interest rate be made normal.

The last time the repo rate was reduced was on March 19 when it was cut by 0.25 percent, a change understandably ignored by commercial banks and other financial institutions. With the repo rate at 7.5 percent and inflation down to 5.9 percent, the market expects the RBI to cut the repo rate further at its next policy review on May 3.

At 7.5 percent, the repo rate is still too high to rev up GDP growth. Interest eats into the profitability of companies and reduces their rate of return. This directly hits stock prices and makes it difficult for companies to raise equity capital that is critical to fund investment. High interest rates significantly increase EMIs on home loans and affects demand for other durable consumer goods such as cars which are bought on credit. No wonder growth in industrial production dropped to less than a percent in 2012-13.

The RBI’s monetary policy seems to be influenced by two considerations. The interest rate has to be above the rate of inflation and there should a minimum margin between the repo rate and the rate of inflation. That is not how other central banks are managing their money.

In a sample of 10 countries, only half had their central bank lending rates above the rate of inflation. These were China, India, Japan, Russia and South Korea – with the average central bank rate at 4.9 percent and average inflation at 3.1 percent. That accounts for a margin of 1.8 percent between interest rate and inflation. Five others – the euro zone, Indonesia, Turkey, the UK and the U.S. – ignored inflation altogether. In this case, average inflation was at 3.8 percent while the average central bank lending rate was 2.1 percent.

Central banks in most countries, even the European Central Bank, did not aim for a single-digit inflation target. In adverse economic conditions, growth and employment matter more and the rate policy makes inflation almost secondary. Taking all the sample countries together, the average inflation rate and the average lending rate of central banks were nearly equal.

The experience of the past three years of inflation in India has made it amply clear that a high rate of interest does not check inflation but certainly checks growth and employment. That is too much of a price to be paid for the conservatism of our central bank. The RBI annual review in May offers an excellent opportunity to look at other policy objectives which have been deliberately overlooked and engineer successive cuts in the repo rate to bring it in line with inflation before the year ends.

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