Factors influence the RBI’s decision on rate cuts

Source: The post factors influence the RBI’s decision on rate cuts has been created, based on the article “Food or the Fed – what will drive the RBI’s monetary policy?” published in “Indian express” on 29th May 2024.

UPSC Syllabus Topic: GS Paper 3– Economy- mobilisation of resources

Contest: The article discusses the Reserve Bank of India’s decisions to adjust interest rates in response to inflation trends and external influences like U.S. Federal Reserve policies. It questions whether future rate decisions will be based on domestic inflation, specifically food prices, or external economic pressures. Factors influence the RBI’s decision on rate cuts

For detailed information on Inflation In India read this article here

For detailed information on RBI’s approach to controlling inflation read Article 1, Article 2

What is the current inflation situation in India?

1. Current Inflation Rate: As of April, the consumer price index (CPI) in India stood at 4.83%.
2. Core Inflation: Core inflation, which excludes volatile food and fuel prices, is at a multi-year low of 3.2%, indicating subdued underlying demand.

3, Food Inflation: Despite lower core inflation, food inflation remains high at 8.7%. This reflects significant price increases across several food groups.

4. RBI’s Inflation Forecast: The Reserve Bank of India forecasts that inflation will average around 4.5% in the fourth quarter of the fiscal year 2024-25, based on current trends and expected conditions.

What is the global context of interest rates?

1.US Federal Reserve: Initially, there were expectations of three rate cuts in 2023, but recent inflation data and Fed commentary suggest only one cut might occur. The Fed aims to keep rates higher for longer.

2. European Central Bank (ECB): The ECB plans to cut rates this summer, emphasizing a data-dependent approach that is independent of the Fed’s decisions.
3. Bank of England: Similar to the ECB, the Bank of England is likely to reduce rates soon, focusing on domestic growth and inflation dynamics.
4. Influence on RBI: These international trends raise questions about whether the RBI will align its policies more with global changes or domestic economic conditions.

How did external factors influence the RBI’s decision?

1. Interest Rate Differential: The RBI’s decision to raise rates in May 2022 might have been influenced by the need to maintain the interest rate differential with the U.S., following a significant rate hike by the U.S. Federal Reserve on the same day.
2. Exchange Rate Stability: By adjusting interest rates, the RBI likely aimed to stabilize the exchange rate and prevent the rupee’s depreciation.
3. Global Economic Trends: The global context, especially the U.S. Fed’s actions, appears to have played a role in the RBI’s decision-making, reflecting concerns over external economic pressures and their potential impacts on India.

1What will be the RBI’s decision on rate cuts?

1. Inflation Projections: With the RBI projecting inflation to average around 4.5% by the fourth quarter of 2024-25, and core inflation currently at a low of 3.2%, there might be room for monetary easing if trends hold.
2. Food Price Expectations: An above-normal monsoon is expected, which could moderate food prices and help align headline inflation with RBI targets, supporting the case for rate cuts.
3. Interest Rate Comparison: The current repo rate is 6.5%; with projected inflation at 4.5%, this suggests a real rate of 2%, which might be adjusted downwards to stimulate economic growth, according to external member Jayanth Varma’s views on aligning inflation to the target.

Question for practice:

Examine how external factors, such as global interest rate trends and the U.S. Federal Reserve’s policies, have influenced the Reserve Bank of India’s decisions regarding adjusting interest rates and managing inflation.