High inflation and negative real rates put RBI in a sticky spot

With the December CPI inflation moving up to 7.35 per cent, there is a lot of noise over real interest rates turning negative. The repo rate at 5.15 per cent, implies a transient, but worrisome 220 basis point negative real rates that has triggered concerns over the end of monetary policy easing and even talks of rate hikes.

Purely on numbers, there is enough merit in these arguments, given that overall CPI inflation number could remain around the 5-6 per cent mark for most of 2020. But underlying weak economic growth, sombre bank credit offtake, still high term spreads, and weak transmission of rate cuts, present a compelling case for the RBI to retain its current stance. A sudden reversal in policy change at this juncture could be detrimental. Given that savings growth have already been trending down, the intermittent negative real interest rates may not have a significant impact on savings, though deposit rates could fall further.

It may be time for the RBI to review its inflation targeting pitch and take stock of other critical factors. After all, a high inflation accompanied by low growth calls for supply side reforms, rather than demand boosters.

Transitory impact

The main cause for the recent rise in CPI, has been the sharp rise in vegetable prices. While the increase in vegetable prices may moderate, the rise in prices of pulses, eggs and meat (essentially protein inflation) is a worrisome trend. Uptick in global commodity prices is also weighing on domestic inflation. Impact of rise in crude prices and telecom tariffs which will be felt in the remaining months of this fiscal, is likely to keep CPI inflation around the 7 per cent mark for the rest of this fiscal.

While the overall CPI inflation is expected to average at about 5 per cent for FY20, it is expected to remain at 5-6 per cent until the latter part of this calendar year.

This implies two things. One, we could have negative real rates for a few more months (purely on point to point basis), which perceptibly has an impact on savings growth. Two, if one were to consider the RBI’s inflation target at 4 per cent with a range of +/-2 per cent, then this limits further rate actions. In fact, it has also opened up possibilities of a policy reversal and rate hike.

While purely on the CPI reading these are valid theories, there are several critical points to note here.

One, negative real rates should be viewed more from a long term perspective. Reading into point-to-point short term trends can be misleading. Given that inflation could average at 5 per cent for the whole of next fiscal (FY21), jumping the gun on negative real rates is unwarranted. Also savings growth has been falling over the recent years, when real interest rates were high. Since mid of 2014, real rates (repo rate less inflation) has been in the 1.5-2 per cent range. But despite the RBI able to contain inflation and keep real rates positives, savings growth has been moving lower. From about 34 per cent of GDP, savings is now hovering at 30 per cent levels.

“Ironically, savings growth has fallen over the period when CPI inflation targeting succeeded. This implies that savings growth is more a function of income growth. Absent supply reforms, stagnant incomes have probably been the largest reason CPI has been well behaved so far”, says Suyash Choudhary, Head, Fixed Income at IDFC AMC.

Beyond inflation targeting

The RBI has been rigid on its CPI inflation target. While this is imperative, the central bank may have to consider inflation along with the changing narrative around growth and income levels. While the inflation targeting suggest that inflation could be within a band of 2-6 per cent, the RBI has been stuck with the 4 per cent number. Given the transient supply side shocks leading to rise in food prices, the RBI would do well to allow itself the leeway of a 6 per cent inflation.

The central bank will also need to take stock of the sharp slowdown in the economic growth. After four straight years of single-digit growth, bank credit did claw back to a double-digit growth of 12 per cent by March 2019, but slipped subsequently and is at just 7 per cent currently.

“A stead-fast single-point CPI inflation targeting---driven by the food basket---was always expected to get tricky at some point. Now this reading is at a multi-year high when income growth has stagnated, many mid-sized balance sheets are struggling and lenders are impaired and growth is significantly below potential. The RBI will have to consider the supply driven inflation and communicate its path clearly,” opines Suyash.

Weak transmission

While a policy stance reversal or rate hike is unwarranted at this juncture, further rate cuts will also need to be considered carefully, given the weak transmission. While the RBI has cut rates by 135 bps whole of last year, average lending rates (on fresh loans) have come down only by 50 bps so far.

One of the key factors for weak transmission has been the wide spread between ten-year government bonds and shorter tenure bonds. In a bid to ease interest rate on long-term government bonds, the RBI has been announcing simultaneous sale and purchase of government bonds (operation twist), using proceeds from the sale of short-term securities to buy long-term government debt papers. While this had resulted in the spread between 10-year G Sec and two-year government securities (that had widened to 90-100 basis points), to narrow to 35 bps, the gap has widened again to 50 bps with the recent rise in inflation. Growing concerns over fiscal slippages can keep 10-year G-Sec yield elevated, accentuating the problem.

Picture this, 13-year government bond yield is at 7.2 per cent currently. Corporates having to borrow at much higher rates, have little incentive to do so, given that the nominal GDP growth is expected at 7.5 per cent this fiscal. Unless term spreads compress, further repo rate cuts will not matter much.

Hence the RBI will have to weigh all factors, before further rate action. At a time when supply side shocks are leading to softness in demand and high inflation, repo rate cuts may achieve little.

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