Why the Reserve Bank needs to change its stance on interest rates
rate is a very important variable in any economy. It impacts investments by entrepreneurs for creation of capacities, i.e. growth, it impacts financial investments, and retail borrowings for consumption purposes, e.g. house, car, etc.
The fulcrum for deciding the spectrum of interest rates in our economy is the RBI repo rate, currently at 6.5%, which is taken as the signal rate for the ecosystem. On its part, the RBI looks at many factors for deciding the repo rate, the most important parameter being inflation, as the real interest rate in the economy should be positive in the interest of savers. Other factors are GDP growth rate, currency exchange rate, global interest rate movement, etc.
Apart from the signal rate i.e. repo rate of 6.5%, there is a policy rate stance of the Monetary Policy Committee (MPC), which gives the future guidance. An easing stance, called ‘dovish’ means the MPC will have a preference for reduction of the policy rate, depending on the variables mentioned above. A tightening stance, called ‘hawkish’ means the MPC will have a bias for rate hikes, depending mostly on inflation. A neutral policy rate stance implies that the MPC will change interest rates only when there is a compelling reason.
The juncture where we stand today is remarkable: we have consumer price inflation (CPI) of 2.33% in November, much on the lower side by Indian standards. However, the policy rate stance of the RBI MPC is ‘calibrated tightening’ i.e. they would look to gradually hike interest rates. The stance was changed from neutral to hawkish in the review meeting held on 5 October 2018, and was maintained in the meeting on 5 December 2018.
What is the objection to the hawkish stance? When interest rates are high, vis-à-vis inflation, it is loaded in favour of the saver, which is fair to that extent.
However, the RBI has to walk the fine line for balancing the interests of the saver and borrower. Capital is an important ingredient for production, and a higher-than-warranted interest rate is disincentive to the entrepreneur, since money is available to her at a relatively higher cost.
In a way, the ecosystem is giving a message to the entrepreneur that we do not want you to create fresh capacities, which would have led to economic growth for the country. Same logic applies to personal consumption loans as well; if loans are available at attractive rates, consumption purchases like house or car or domestic appliances would lead to demand, and thereby have better growth for the economy.
Currently, not only is inflation on the lower side (2.33% in November), RBI’S projections are on the lower side as well. In the MPC meeting held on 5 December 2018, the inflation projection is 2.7-3.2% for the period October 2018 to March 2019 and 3.8-4.2% for April 2019 to September 2019.
This is benign, very much within RBI’S target inflation rate of 4%. That being the case, rate hike bias is inimical to growth prospects for the country. Economists are discussing the probabilities of interest rate cuts in 2019, driven by benign inflation.
However, for the RBI MPC, prior to a rate cut action per se, the outlook has to be changed. It is not possible for them to reduce interest rates while maintaining a hawkish rate stance; it has to be changed to neutral.
The next meeting for the RBI MPC is scheduled for 7 February; it is high time they change course in the interest of growth of the country. The other possibility is change of stance and rate action on the same day, but that may be expecting too much.
Hence, the likelihood is, they would shift to neutral on 7 February 2019 and take rate action in April 2019, depending on inflation trajectory and other relevant parameters. The biggest component of CPI, which is food, has seen a consistent decline over the last five years, and is currently negative on year-on-year measurement.
Though food inflation would not remain negative in 2019, there is a structural improvement in food inflation, and the benefit should be transferred to the economy in terms of lower interest rates.
Net-net, given the higher likelihood of interest rate cuts in 2019, it would be better for your home or car loans, but please take care of financial planning. Things should be proportionate and loans should be within a certain percentage of your net-of-tax earnings.
Lower interest rates are better for your existing investments as well; equities driven by better earnings prospects of companies (lower interest cost) and debt driven by interest rates coming down (bond prices move inversely with interest rates). Lower interest rates are not so good for fresh investments in debt, as you would be doing it at relatively lower interest rates, but the impact would not be as much as to alter your portfolio allocation decision.
Joydeep Sen is founder, wiseinvestor.in