RBI’s turn to bat

Just about, though. The battle with inflation is far from won. Living costs for households continue to rise at 11% from December 2012; a full percentage point higher than consumer price inflation observed in the preceding three months. Driven by food or otherwise, that’s the inflation households face. Non-food, manufactured goods inflation, to which RBI responds, essentially reflects stable commodity prices with some reduction in pricing power as demand slows. Not surprising then that RBI reiterated its January guidance of whoesale price inflation persisting in the 6.5-7% in 2013-14. This should be the floor though: if GDP growth picks up as expected and global growth recovers, the interplay of global liquidity with a rebound in demand will result in higher commodity prices feeding back into domestic inflation.

The interest rate cuts work for the production side of the economy. They also help the government to borrow cheaply. But the returns from capital must be distributed more evenly across different segments to avoid distortions. Monetary policy sets the threshold for nominal interest rates, which then transmits through different channels to determine returns on different assets. In a high-inflation environment, a divergence in returns can lead to incompatible incentives for savings and investment. Savers turn away from deposits into stocks, gold, real estate; when stocks are not trusted and property is untouchably expensive, they embrace gold. This is what has been happening in India, slowing down the growth of bank deposits, interest rates on which bankers are quick to reduce when the cycle trends downwards but are loath to raise in reverse. Hence, deposit growth remains two percentage points lower than credit growth on a six-month trend, with 79% of banks’ deposits loaned out by February 2013. This, in a low-growth environment.

Meanwhile, savers’ penchant for gold is under scathing criticism and import duties have been raised to save the current account deficit (CAD) from ever-rising gold imports. In his recent speech, RBI governor D. Subbarao clarified the relationship between interest rates and the current account gap in India: import demand responds more robustly to income changes than interest rates, he argued, while the domestic-foreign interest differential matters less for India in the conventional sense in determining foreign capital inflow due to vast differences in the openness of equity vis-à-vis debt markets. An important link was missing though: the real return on domestic financial assets, when negative or too low, propels demand for gold that is directly fed by imports. In its inter-quarter review, RBI flagged CAD as unsustainable, a key risk whose financing remains a challenge. Yet—and like the budget before this—external adjustment is considered more medium-term, with structural factors like export competitiveness and measures to curb unproductive import demand (read that as import duties and inflation-indexed bonds, with as-yet-unproven efficacy) to fix the problem.

Looking ahead, even as monetary policy stance shifts some more towards growth, the wholesale retail inflation wedge and its influence on inflation expectations, along with pressures from food and administered prices’ pass-through and CAD risk will determine the future path of interest rates—into a neutral zone; further lowering of interest rates can be excluded in the near-term.

Renu Kohli is a New Delhi-based macroeconomist; she is currently lead economist, DEA-Icrier G20 research programme and a former staff member of the International Monetary Fund and Reserve Bank of India.