The moment has finally come.
On September 18, the US Federal Reserve eased interest rate by 50 basis points (bps). Globally, central banks are easing interest rates. For instance, the European Central Bank (ECB) has cut rates twice. Many developed and emerging economies such as Switzerland, Sweden, Canada, Brazil and Peru have eased interest rates. China has been easing interest rates for a long time. Now the big question is: when will India’s Reserve Bank of India (RBI) cut interest rate? Let’s take a step back and understand what the RBI’s monetary policy committee (MPC) will look at during its next policy review meeting to be held between October 7 and 9.
What is interest rate?
Interest rate is the balancing aspect between savers and borrowers in a bid to keep inflation and economic growth at an even keel. It should be high enough so that savers get a fair deal and feel induced to save. Simultaneously, it should be low enough so that borrowers are incentivised to borrow.
Borrowers refer to retail individuals, small industries, service industries, large industries, etc. Loans are utilised for some economic activity such as either investment (in business) or consumption (house, mobile phone, vacation). When interest rates are low, loan off take is higher. As a result, more people take loans. With higher economic activity, while gross domestic product (GDP) growth is higher, it is pro-inflationary.
When inflation is high, the central bank, RBI, increases interest rates. Loan off take is expected to come down, which slows down economic activity, and consequently is expected to ease inflation. When inflation is low/under control and growth is challenged, the RBI eases interest rates to induce economic activity. The signal for increasing or decreasing interest rate is given through the repo rate, which is at 6.5 per cent. Changes in repo rate percolates to the economic system, though with a time lag.
What is the current situation?
Based on multiple variables, the MPC takes the decision to change the repo rate. The key variable is inflation. In July, consumer price index (CPI) inflation eased to 3.6 per cent and it was 3.65 per cent the following month, aided by a favourable base effect. The figure is well below the central target of the RBI, which is 4 per cent +/- 2 per cent. GDP growth is buoyant. It was 8.2 per cent in financial year (FY) 2023-24 and 6.7 per cent in first quarter (April-June), FY24-25. However, as a growing economy, growth is vital for us. As long as inflation is under control, it does not do any harm to ease interest rates and also gives an impetus to growth.
The moot point is: to what extent can interest rates be eased.
The MPC does not go by the latest declared data point, which refers to August CPI at 3.65 per cent. CPI inflation for 2024-25, as projected by the RBI, is 4.5 per cent. Going by this parameter, repo rate being 6.5 per cent, there is 2 percentage point positive interest rate, which is on the higher side and calls for rate cuts. The repo rate is the rate for overnight lending by the RBI to banks, whereas inflation is measured with a one-year gap. The one-year interest rate is a better parameter. The yield (interest rate) on one-year Treasury Bill is around 6.75 per cent. So, the positive interest rate is more than 2 percentage point.
Also read | RBI's rate cut dilemma: Keep pace with Fed's 50 bps slash or take slow path to easing?
Who decides interest rate cut?
The MPC comprises three officials from the RBI, including the governor, and three external experts nominated by the government. The tenure of the three external members have come to an end. We expect three new members to be nominated before October 7 — the day the next review meeting starts. The tenure of the governor expires by the end of this calendar year. The next MPC meeting after October is slated to be held between December 4 and 6. In the previous MPC meeting, which was held in August, the members voted 4:2 about the interest rate cut. Four members voted for a pause in repo rate and two external members voted for a rate cut by 25 bps.
Also read | What should India’s fixed-income investors do after US Fed rate cut?
What's the argument about interest rate cut?
Inflation is within the RBI's target band. Though growth is buoyant, entrepreneurs and consumers should not be burdened with an interest rate higher than that required to keep inflation under control.
The relevance is about the currency. There is a belief that lower interest rate may weaken the exchange rate. The concern has been addressed owing to the global trend of interest rate cuts. Typically, MPC deliberations are often guided by global events.
There is another aspect to it. Apart from the repo rate at 6.5 per cent, there is a policy stance. The current stance is ‘withdrawal of accommodation’. However, after the review meeting in February, 2023, the RBI has not withdrawn any accommodation. There has been a pause in every review meeting. With inflation under control, there is no need for any withdrawal either. Hence the stance of ‘withdrawal of accommodation’ is outdated and calls for a change to neutral.
Will India cut interest rate?
The decision will be known after the conclusion of the next MPC meeting on October 9. If not a rate reduction per se, it is high time for change of stance to neutral, in tune with the global trend.
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