Why the Re­serve Bank needs to change its stance on in­ter­est rates

Mint Asia ST - - Otherviews -


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

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