March 15, 2016: Low Retail inflation and demand for a rate cut

March 15, 2016: Low Retail inflation and demand for a rate cut

General Studies: Daily Capsule

Curtain Raiser –News Update (March 15, 2016)

Low Retail inflation and demand for a rate cut:

I would like to quote a few statements from the article titled “India raises interest rates to combat inflation” that appeared in the Financial Times dated January 28, 2014 so as to appreciate the current scenario of low Retail inflation and demand to rate cut.

“Announcing the 25 basis point rate hike to 8 per cent, which surprised markets, Mr Rajan insisted that reducing consumer prices was essential, even as he admitted that the slowdown of the country’s growth was “increasingly worrisome”. [statement 1]

“However, Mr Rajan’s argument is that over the long-term, keeping a lid on inflation would help the economy expand. “The so-called trade off between inflation and growth is a false trade-off in the long-run,” he said in a televised statement after announcing the rate rise. “Elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This in turn discourages investment and weakens growth.” [statement 2]

“The rate decision was not welcomed in the business community, which argued that rate rises were hampering demand and hurting investment and therefore growth.” [statement 3]

“Late last week, the RBI committee appointed by Mr Rajan recommended the central bank adopt an inflation target of 4 per cent, with a band of 2 per cent on either side. It has also proposed what Mr Rajan called a two year “glide path” to bring down retail inflation to below 6 per cent.” [statement 4]

“In his statement, Mr Rajan said he was still studying the proposal to move the RBI to formal inflation targeting, with policy decisions taken by a binding vote of a Monetary Policy Committee. But he said he believed the plan of cutting the retail inflation rate to 6 per cent within two years was a reasonable goal that the bank would try to meet.” [statement 5]

What we can infer from above statements?

Whenever there is rise in interest rate, the business community will be worried. As the popular perception is that rate rise hampers demand and hurts investment and therefore growth [statement 3].

Changes in monetary policy aimed at contracting aggregate demand can be described as raising the interest rate; and Changes in monetary policy aimed at expanding aggregate demand can be described as lowering the interest rate.

So the popular perception that increase in interest rate will hurt growth is true but one side of the coin.

The other side of the coin is beautifully explained in the above [statement 2. : keeping lid on the inflation would help economy expand…..  “Elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This in turn discourages investment and weakens growth.”

This is the basis for inflation targeting. And the RBI committee’s recommendation to the central bank to adopt inflation target of 4 per cent, with a band of 2 per cent on either side was the right direction in inflation targeting. Further RBI Governor’s assertion at that time that inflation target of 6 per cent is achievable in two years has come true.

Now the Retail inflation has come down to 5.2 per cent for Feb 2016 from 5.7 per cent in the preceding month. The condition Mr. Rajan was waiting for has arrived. And perhaps it is the right time to lower the interest rate.         

References:

1.      1. India raises interest rates to combat inflation,  dated January 28, 2014, Financial Times

 https://next.ft.com/content/18dc0d04-87e7-11e3-a926-00144feab7de

2.     2.  Retail inflation at four-month low, spurs calls for a rate cut, March 15, 2016, The Hindu