Falling retail price inflation on the one hand, and the unchanged interest rate on the other, raise the question of whether the real interest rate in India is too high to revive stagnant investment and thus stimulate growth.
Falling retail price inflation on the one hand, and the unchanged interest rate on the other, raise the question of whether the real interest rate in India is too high to revive stagnant investment and thus stimulate growth. The Consumer Price Index (CPI) hit an 18-month low at 2.19% in December 2018 and wholesale price inflation hit an eight-month low at 3.80%, due to falling food and energy prices. This widened the gap between the nominal interest rate and inflation.
The real interest rate, which reflects the real cost of borrowing, has a significant impact on investment decisions. According to a working paper published by the RBI, a one percentage point increase in the real lending rate reduces the real investment rate by around 0.3 to 0.4 percentage points.
The question is of immense importance in light of rising interest rates in developed economies after years of near zero interest rates. The real interest rate in India is 4.3 percent which is high compared to other emerging Asian economies such as China, Bangladesh, South Korea, etc.
As actual inflation numbers continue to be lower than the RBI forecast, the RBI is likely to change its stance to become neutral on the calibrated tightening of February 2019, said Sameer Narang, chief economist, Bank of Baroda, at Financial Express Online. “The continued underestimation of inflation, coupled with declining global oil prices and subdued global growth prospects, is prompting the RBI to change its stance before cutting rates,” Sameer Narang said.
However, there may be concerns about a rise in inflation, preventing the RBI from being too accommodating. Going forward, as predicted by ICICI Bank, inflation is expected to increase with a possible reversal in food prices and increased public spending due to the upcoming general election.
“The RBI targets inflation and as long as core inflation is high at 5.5-6 percent, it will not lower the interest rate which is the only factor affecting growth,” said Madan Sabnavis, Chief Economist, CARE Ratings, at Financial Express Online. . He also highlighted the weak demand due to low incomes of farmers and limited private investment and suggested solving the NPA issue with the highest priority.
Sujan Hajra, chief economist, Anand Rathi, also agrees that inflation will not be so low for a long time. He said he expects a total decline of 75 basis points over the course of 2019, expecting the central bank’s stance to shift from calibrated tightening to neutral. He also expects the RBI to continue its open market operations to keep cash flow in the economy.
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