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Last week, RBI Governor Shaktikanta Das said it was premature to discuss rate cuts, as inflation continues to hover around 5%. This stance provides no clear guidance to market players, stakeholders, and others. While rate cuts are highly anticipated, it is likely that the Reserve Bank will maintain the status quo for a while, given the uncertain outlook for food inflation and geopolitical circumstances. Throughout the year, Das has emphasised the need for the monetary policy committee to be vigilant about the upside risks that might derail the path of disinflation. Therefore, the current policy must remain actively disinflationary to anchor inflation expectations.
The policy repo rate has been unchanged at 6.50% since February 2023, while the RBI maintains a policy stance of withdrawal of accommodation. However, the central bank cannot issue any forecasts due to precarious weather conditions, with potential events like monsoon flooding posing a risk. Another critical aspect influencing the RBI’s decision-making is the labour market. Employment trends can significantly impact inflation and economic growth. For instance, a tight labour market with rising wages can lead to higher consumer spending and inflation, necessitating a higher repo rate to cool down the economy. Conversely, high unemployment rates may prompt the RBI to lower the repo rate to stimulate job creation and economic activity.
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The central bank closely monitors employment data to gauge the overall health of the economy and adjust its policies accordingly. Instead of extending rate cuts, the government may push for tighter monetary policy to tame inflation. The government faces the tough task of balancing growth and inflation. While an overly tight policy might hinder economic growth, a lenient one may exacerbate inflation.
Repo rate and inflation
One of the RBI’s most important tasks is to develop a thorough monetary policy, primarily managed through the repo rate or repurchase rate. This benchmark interest rate facilitates the smooth operation of the monetary system and is the interest commercial banks pay to the RBI for overnight loans secured by securities. The repo rate is the most crucial tool in the RBI’s arsenal to manage money in the economy.
By adjusting the repo rate, the RBI influences the cost for banks to borrow money, triggering a ripple effect throughout the financial system. Higher repo rates lead to more expensive loans for businesses and individuals, potentially slowing economic growth but keeping inflation in check. Conversely, lower repo rates can stimulate borrowing and investment but carry the risk of rising inflation. The repo rate also influences foreign investment and currency exchange rates. When the RBI wants to increase money availability, it lowers the repo rate. Conversely, the repo rate is increased to discourage banks from borrowing money, thereby reducing the money supply.
Factors affecting interest rates
Domestic factors, such as the demand and supply of money, fiscal deficit and government borrowing, and inflation, are considered when forming monetary policy. A growing economy with high demand for loans pushes the repo rate upwards. Conversely, a sluggish economy with low borrowing demand can lead to a lower repo rate. Additionally, an increase in money supply, like the temporary surge after demonetisation, can bring the repo rate down. To maintain positive real returns for savers and investors, the repo rate may need to adjust in response to inflationary pressures. Financial stability is another paramount concern for the RBI.
Ensuring the stability of the banking and financial system is crucial, as any significant disruptions can have severe repercussions on the economy. The RBI’s monetary policy aims to mitigate risks such as non-performing assets (NPAs) and maintain the overall health of the banking sector. By managing the repo rate, the RBI can influence the lending and borrowing practices of commercial banks, thereby promoting financial stability and preventing systemic risks.
Beyond domestic factors, the repo rate is also influenced by global trends. As India’s economy becomes more integrated with the world, the RBI must consider global interest rates. If global interest rates rise, India may need to raise the repo rate to remain competitive and attract foreign capital, supporting the Indian rupee’s exchange rate. Conversely, during global economic downturns, the RBI might need to lower the repo rate in line with other central banks to stimulate domestic borrowing and investment.
Another global factor that the RBI must consider is the geopolitical climate. Events such as trade wars, international sanctions, or political instability in key trading partners can impact global financial markets and, consequently, India’s economy. The RBI must be agile in responding to these external shocks, adjusting the repo rate as necessary to safeguard the Indian economy from adverse global developments. Such geopolitical uncertainties require the central bank to maintain a flexible and responsive monetary policy framework.
Outlook for repo rate
According to Singapore-based DBS Group, the RBI may keep the repo rate unchanged at 6.5% for the rest of the calendar year. While three Monetary Policy Committee (MPC) review meetings are scheduled this year in August, October, and December, the MPC is unlikely to relent in the short term. A prolonged heatwave and a rainfall shortfall in June hurt vegetable production and drove prices higher, according to a DBS Group research note.
The RBI Governor has also emphasised the need for caution in the upcoming months, suggesting that the policy committee will prefer to extend its wait-and-watch position. Domestically, various factors weigh against a repo rate cut, including heightened vegetable prices in June, pressure from a telecom tariff hike, and a moderate rise in kharif MSPs (minimum support prices). Even if rainfall improves in July, vegetable prices are expected to moderate slightly.
Additionally, consumer confidence plays a significant role in shaping monetary policy decisions. High consumer confidence typically correlates with increased spending and borrowing, which can drive economic growth but also contribute to inflation. Conversely, low consumer confidence can lead to reduced spending and economic stagnation. The RBI must balance these dynamics, using the repo rate to either stimulate or cool down consumer activity based on prevailing economic conditions. Tracking consumer sentiment through surveys and economic indicators helps the RBI tailor its monetary policy to the current economic landscape.
As more clarity and certainty emerge over the monsoon and food prices, the space to cut interest rates may develop. However, economists argue that maintaining a high real interest rate is crucial for India compared to the Western world. This is because India’s inflation, both targeted and actual, is significantly higher. A real repo rate below 2% could be too stimulative for the economy, especially considering India’s potential GDP growth exceeding 5%.
With inflation, particularly food inflation, still above target, the RBI should prioritise controlling inflation by holding the repo rate steady. In conclusion, the RBI’s approach to managing the repo rate involves a delicate balancing act, considering a myriad of factors from domestic economic conditions to global trends and geopolitical developments. By maintaining a vigilant and adaptive stance, the central bank aims to foster economic stability and growth while keeping inflation in check. The coming months will be crucial in determining how these various factors evolve and influence the RBI’s policy decisions, ultimately shaping the trajectory of India’s economic future.