Why the RBI kept interest rates unchanged despite demonetisation

The RBI has kept the repo rate unchanged at 6.25%. Photograph:( AFP )

WION New Delhi, India Dec 07, 2016, 02.23 PM (IST) Vrinda Aggarwal

The 6-member monetary policy committee (MPC) of the RBI met for the second time since its inception to decide on the key monetary policy indicators of India. The decision taken by the MPC comes as a shock to many as one of the key rates i.e. the repo rate has been kept unchanged at 6.25%.
 
Repo rate is the rate at which banks borrow from the RBI.
 
Most of the experts, economists and bankers had predicted that the repo rate would be cut by 25 to 50 basis points at the back of slowdown of consumer price index (CPI) and a potential slowdown of the economy due to demonetisation.

CPI is a number that refelects the average price of a basket of consumer goods such as transportation, food and medical care. It is one of the most frequently used statistics for identifying periods of inflation or deflation.

Economics behind cut in the repo rate
 

If the repo rate is cut, then the banks would be able to borrow at a lesser rate and then, they can pass this to the end-consumers by reducing the lending rates. Reduced lending rates would encourage people to take loans for businesses, education, buying a house and other personal needs, thus increasing the GDP of the country and subsequently the economic growth as well.
 
However, there is another side to the story. If people are borrowing more, this implies that there are higher investments in the economy. High investments imply increased employment and thus, rise in the demand for goods and services, increasing the price level in the economy.

Whenever the MPC meets, they always have to face this dichotomy of chosing between higher economic growth versus high price levels.
 
Current decision of MPC
 
According to the statement of India’s central bank, Reserve Bank of India's governor Urjit Patel, the reason behind keeping the repo-rate unchanged is to meet the inflation targets of 5% (with a plus-minus of 2%) for the last quarter of the financial year 2016-17.
 
It seems that the inflation targeting took precedence over any other consideration while deciding the repo rate. Three main reasons that seem plausible for such hawkish approach are:

  • Implementation of seventh pay commission recommendations can lead to rise in inflation  
  • Rise in domestic food prices
  • Rise in crude oil prices after OPEC’s decision to cut production

 
In the past couple of weeks, post demonetisation several experts and prominent organisations have cut down the GDP forecast for Indian economy. Even the RBI today cut the growth forecast for this fiscal from 7.6% to 7.1%.  Thus, experts believed that RBI would cut the repo-rate to stimulate the economy and achieve the growth targets.
 
However, it is believed that with the deposit of Rs 11.55 crore in banks post-demonetisation, there is excess liquidity in banks which would anyways encourage the banks to reduce their lending rates whether the repo rate cut happens or not.
 
Some private banks like ICICI, Axis bank and Bank of Baroda have already reduced their lending rates in the past week before the meeting of MPC.
 
No sweat over liquidity crunch
 
Post-demonetisation, the Indian economy is reeling under liquidity crunch with thousands of people queuing outside ATMs and banks each day to withdraw money. 
 
During the press conference, RBI officials showed fair amount of confidence and said that the situation is under control as far as the liquidity is concerned. According to RBI officials, the remonetisation exercise is in full throttle with all the five printing presses of both RBI and government working to full capacity to print new notes. From November 10th to December 5th, RBI has printed currency worth Rs 4 lakh crore of higher denominations like the Rs 500 and Rs 2000 and during the same period, around 19.1 billion pieces of Rs 100, Rs 50 and Rs 20 denomination notes were printed.
 
The RBI officials also mentioned that they may reduce the number of notes being printed as people are increasingly moving towards digital modes of payment.  
 
Clear distinction between monetary and fiscal policy
 
Going by the textbook, the main monetary policy indicators are price level and money supply and the monetary policy lies in the domain of the central bank of a country, in this case, RBI.
 
The fiscal policy is the domain of the government of a country and both the monetary and fiscal policy have to work in tandem for the future growth and economic stability of a country. 
 
Today, it can be observed that the RBI stuck to its side of the policy mandate, focusing completely on inflation targeting and trusting the government to work on the GDP front.

In the coming months, one should be on the lookout for the figures of the major economic indicators to get a sense of how the demonetisation policy has worked for India.

(WION)