The RBI is unlikely to cut interest rates: with rising inflation, India’s central bank has tied its hands

Representative picture.

Representative picture. | Photo credit: PTI

Key highlights

  • At the start of the COVID-19 outbreak in India, the RBI moved swiftly to cut interest rates in hopes of stimulating economic activity without considering the inflationary pressures that followed.
  • However, in the last four policy reviews, the Monetary Policy Committee decided not to cut the key rate any further, as concerns about rising inflation take priority
  • After the previous monetary policy review, the RBI admitted: “The inflation outlook has turned negative compared to expectations over the past two months.”

The Reserve Bank of India’s Monetary Policy Committee decided on Saturday to continue its accommodative monetary policy stance, with members noting that any change could jeopardize the looming recovery.

Despite a historic decline in the first quarter of the fiscal year, the economy contracted less than 7.5 percent in the September quarter. However, what has been particularly worrying in recent months is the persistently high rate of retail inflation, which has limited RBI’s options.

In November retail inflation was a worrying 6.93 percent. RBI has a legal obligation to keep retail inflation within a range of 2% and 6%.

At the start of the COVID-19 outbreak in India, the RBI moved swiftly to cut interest rates in hopes of stimulating economic activity without considering the inflationary pressures that followed. Since the lockdown in March, the RBI has done a large part of the effort to alleviate the country’s economic plight, and the central government’s fiscal incentives have been heavily criticized for their tepidity.

However, in the last four policy reviews, the Monetary Policy Committee decided not to lower the key rate any further, as concerns about rising inflation take priority. The reality is that India’s retail inflation – as measured by the consumer price index – has been well above RBI’s comfort zone almost every month since November 2019.

After the previous monetary policy review, the RBI admitted: “The inflation outlook has turned negative compared to expectations over the past two months.” This justified the central bank to revise its inflation forecast for the quarter from October to December and also for the next two quarters significantly upwards. For the fourth quarter of the current financial year, the RBI expects the Indian CPI to remain high at 5.4 percent and to decrease slightly to 5.0 percent in the first quarter of the next financial year.

The question that many asked themselves at the time is why the RBI did not try to increase interest rates, especially since it is tasked with ensuring price stability in the markets. Some analysts have noted that it is the broad nature of inflation – headline inflation soaring outside the RBI’s comfort zone, double-digit food inflation, and rising core inflation – that has remained in the hands of the MPC.

The central bank has determined that solving the problem with a largely demand-side solution may not yield dividends as rising prices are due to supply-side disruptions, rising indirect taxes, and rising margins. The fuel price continues to rise to an alarmingly high level due to rising indirect government taxes. Fruit and vegetable prices have also risen in recent months after heavy rains that have destroyed crops.

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