When will RBI ease rates? The inflation dilemma explained

Many people, especially those who borrow from banks to buy houses and consumer durables, are asking: When will the Reserve Bank of India reduce interest rates? This piece aims to explain, in simple terms, the complexities behind the RBI’s role in controlling inflation in the current Indian context. 

An unstable inflation rate causes uncertainty around costs, prices, and profits, discouraging businesses from producing and investing. As a result, price stability—meaning a low and stable inflation rate—is considered essential for sustaining a high and stable investment rate, which in turn leads to healthy and stable growth of gross domestic product. 

The RBI projects the GDP growth rate for 2024-2025 to be in the range of 6.5-7%. Meanwhile, retail inflation (or CPI inflation) fell to a near five-year low of 3.64% in July 2024, below the RBI’s inflation target of 4%. But the repo rate, which is the rate at which banks borrow short-term funds from the RBI, has remained unchanged at 6.5% since February 2023, following a steady rise from 4% in May 2022 to curb inflationary pressures.

The ‘elephant in the room’ for the RBI is the food inflation, which stood at 9.36% in June 2024. The majority view of the Monetary Policy Committee (MPC), which directs India’s monetary policy, is that persistent food inflation—now a global phenomenon due to climate change and disruption of global supply networks—could offset the gains from falling CPI inflation. Hence, the RBI is unwilling to lower the policy interest rate until food inflation decreases on a sustained basis. 

Monetary policy seeks to maintain price stability by adjusting aggregate demand through changes in the money supply and interest rates. However, two components of CPI—food and fuel—are largely driven by supply-side forces such as drought, floods, and international oil prices, which, in turn, depend on factors like global boom/recession, war, pandemics, OPEC policy, etc. beyond the RBI’s control. Food accounts for 46% of CPI, while fuel and light accounts for nearly 7%. Recently, the Chief Economic Advisor suggested that the RBI’s inflation target should exclude food. In other words, monetary policy should focus on ‘core inflation,’ which excludes food and fuel from CPI. Core inflation has been steadily falling and has remained below 4% for some time. 

The government has also taken steps to reduce the weight of food in CPI by appointing an expert committee to determine new weights for computing CPI, as the current weights are based on outdated consumption data from 2011-2012. Today’s consumer spends less on food and more on other goods compared to 2011-2012. 

There is concern that food price hikes from supply-side shocks, like droughts, could lead to a more generalised inflation with a time lag as workers demand higher wages to compensate for rising costs. As a result, RBI cannot ignore food inflation in its monetary policy. In addition, when inflationary expectations, which depend on food prices, become anchored at a higher rate, it becomes harder to bring inflation down without causing a sharper drop in GDP growth and a rise in unemployment. Therefore, food inflation remains a critical factor for the RBI.

Several additional factors further complicate the RBI’s task:

First, the role of fiscal policy, which is outside the RBI’s domain, also affects aggregate demand, which, in turn, is influenced by both monetary and fiscal policy. The RBI’s job becomes harder if the government runs a high fiscal deficit (the gap between total government expenditure and income), which adds to aggregate demand. Fortunately, in recent years the Indian government has been gradually reducing the fiscal deficit, which is making the RBI's life that much easier. 

Second, cutting aggregate demand to reduce inflation causes a fall in GDP growth and a rise in the unemployment rate. The RBI cannot ignore these effects. The fact that India continues to be the fastest-growing big economy in the world provides some relief as the RBI pursues contractionary monetary policy to control inflation. 

Third, a lot of short-term funds move across countries in search of higher interest rates. Thus, the RBI cannot afford to cut interest rates unless major economies like the US and European Union also lower theirs.

Fourth, while a lower interest rate helps borrowers, it hurts savers and lenders. In India, in the absence of a social safety net, a large number of people—especially retired people without inflation-indexed pensions—rely on fixed deposit interest for survival. As such, the RBI must balance the interests of both savers and borrowers when setting interest rates.

Fifth, the delayed effect of interest rate changes on aggregate demand and hence on inflation and growth. There are several delays here. Even when the repo rate is cut, the lending rates of banks may not fall immediately, as banks would have a lot of previously borrowed high-cost funds in their portfolio. It also takes time for changes in lending rates to affect investment spending. So, the RBI must wait to see the full impact of rate change before deciding on its subsequent policy actions. 

Sixth, the RBI must be confident that the inflation rate has been brought under control before it reduces interest rates. Otherwise, there is the danger that it may have to reverse its course very soon as inflation picks up again. Stability of policy direction is important for people to retain faith in RBI policy. 

To conclude, currently the majority view in RBI is to wait and watch. Unless it becomes reasonably certain that the back of the inflationary beast has been broken, it would not risk a change in its monetary policy stance.

(The writer is a former Professor of Economics at IIM, Calcutta, and Cornell University, US)