Home / Markets / Mark To Market /  RBI has run out of reasons to slash policy rates in a recessionary FY21

October’s retail inflation print is the ninth monthly one above the flexible inflation target of 2-6% given to the Reserve Bank of India (RBI) by law. In 2020 so far, inflation has been below 6% only in March.

In a normal year, this would have entailed a hike in policy rates because RBI is legally bound to keep inflation within the 2-6% band. However, FY21 is anything but a normal year. India’s economy is estimated to shrink by about 10% in the current fiscal year.

As such, economists are hopeful that RBI delivers one more cut in its policy rate in February. “We expect the RBI to pause at its 5 December policy meeting because of the elevated inflation outturn. However, because of our view of moderating inflation amid the large negative output gap, we maintain our view of 50bp (basis points) of policy easing to be delivered in H1 2021," analysts at Nomura wrote in a note. Those at Barclays supported this view. One basis point is one-hundredth of a percentage point.

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The repo rate, which is 4% at present, would drop to its lowest point of 3.5% if the central bank meets Nomura’s expectations. However, no amount of monetary easing or loose fiscal policy matters if private consumption does not pick up pace.

Here, we come full circle to the rise in inflation. An increase in the retail inflation rate hurts everyone from savers to consumers. Economists have warned that interest rates have turned negative for savers, penalizing them amid a pandemic. Household savings have surged to 21.6% in the April-June quarter as a precautionary move by Indians.

Penalizing savings logically should lead to more consumption and these savings built up during April-June could flow out as consumption expenditure. However, as inflation reduces the value of money, Indians would be less likely to increase consumption. Given that there is still gloom over employment, pushing up consumption will be tough. “Empirical evidence suggests a weak negative relationship between inflation and consumption expenditure. This means that, given their budget constraint, households tend to slow down consumption of non-essentials when prices rise fast," wrote economists at Crisil Ltd in a note.

Thus, unless inflation eases, the recent encouraging recovery reflected in several economic data may flounder. RBI recognizes this risk. In an article in its November bulletin, the central bank had flagged inflation as a formidable risk to the prospects of a recovery. “There is a grave risk of generalisation of price pressures, unanchoring of inflation expectations feeding into a loss of credibility in policy interventions and the eventual corrosion of the nascent growth impulses that are making their appearance," the bulletin said.

India’s economy is a rare spot in the world where inflation is rising despite a recession. It not only complicates policy but also threatens potential growth.

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