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Business News/ Market / Mark-to-market/  The disconnect between inflation and RBI policy rate
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The disconnect between inflation and RBI policy rate

The central bank slowly and steadily brought down interest rates, in spite of inflation remaining very sticky

Graphic: Subrata Jana/MintPremium
Graphic: Subrata Jana/Mint

Reserve Bank of India (RBI) governor Raghuram Rajan’s concern about soaring food prices has been borne out by the numbers. Inflation as measured by the Consumer Price Index (CPI) jumped to the highest level this year in May to 5.76% from 5.47% (revised) in April.

What is more interesting is the fact that in January 2015, inflation was at 5.19%, as shown by the chart, while the repo rate at that time was brought down from 8% to 7.75%. Inflation is currently higher, at 5.76%, but the repo rate is much lower, at 6.5%. What the central bank has done is to slowly and steadily bring down interest rates, in spite of inflation remaining very sticky. As the chart shows, the perception that we have had a steady fall in inflation is incorrect.

Does RBI believe that an inflation rate of 5.76% is compatible with a repo rate of 6.5%? If so, why was the repo rate at 7.75% when the inflation rate was 5.19% in January 2015? Surely the central bank should have cut rates more rapidly?

On the other hand, if RBI believed at that time a repo rate of 7.75% was consistent with inflation of 5.19%, how can it be comfortable with a repo rate of 6.5% when inflation is 5.76%?

True, we are saying all this with the benefit of hindsight and perhaps RBI was no doubt being cautious in reducing the policy rate slowly. Perhaps it believes a good monsoon will lower food prices and inflation. But the chart shows that in August 2015, inflation was much lower at 3.74% and the repo rate was 7.25%. Given that background, surely RBI can be expected to cut its policy rate further only after a substantial drop in inflation from present levels?

That seems unlikely, since a recent RBI professional forecasters’ survey foresees CPI-based inflation at 5.2% in the first quarter of 2016-17 and expects it to remain above 5% till the fourth quarter of this fiscal year.

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Published: 14 Jun 2016, 01:49 AM IST
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