RBI has reduced the repo rate (interest rate at which RBI lends to banks) by 0.5 percent (50 bps) in its latest Monetary Policy Review on September 29, 2015. While RBI was in dilemma, whether to reduce interest rates or not, pressure had been mounting on RBI by figures on inflation, to reduce interest rates in its Monetary Policy Review, in the last week of September 2015.

According to the figures released by the government on September 14, 2015, consumer inflation was estimated at 3.66 % in August 2015, as against 3.69 % a month before; wholesale inflation remained in negative zone for10th consecutive month and was recorded at (-) 4.95 %, which implies that instead of rising, wholesale prices have been declining steadily, and despite monsoon failure, retail inflation has been declining continuously. 

In recent times, the Finance Minister and his colleagues in the government wanted that RBI reduce interest rates to promote growth in the country; the RBI was generally not ready to oblige them citing danger of inflation in the country. Almost every month when date of review of interest rates by the central bank comes nearer, a debate has been a regular feature; that whether RBI would reduce interest rates or not. However, most of the time RBI preferred to disappoint the market.

Recently, after GDP and inflation figures published by the government, situation had become extremely interesting. Based on these figures, the Prime Minister’s Chief Economic Advisor Arvind Subramanian argued that today the economy no longer faces the problem of inflation, rather we are faced with the problem of ‘deflation’. It is notable that this emanates from another measure of inflation, namely GDP deflator; which instead of inflation, is actually hinting towards deflation in the country.

Thus there was a dilemma. On the one hand, India’s Chief Economic Adviser was concerned about a situation described as deflation in the economy, the nation’s monetary policy maker RBI, especially its Governor, was still wary of inflation and therefore was not giving any heed to the demand for a cut in interest rates. 

RBI's Logic 

RBI argued that interest rates can’t be determined without taking into consideration the inflationary situation in the economy. Though rate of increase of consumer price index had come down to 3.66 % in August, against two digits an year ago, which was less than the target 4 %, the RBI was in no mood to consider a decline in interest rates, arguing that perhaps this cooling of inflation, may not last long. 

RBI also said that to discourage the exodus of foreign exchange, again it is essential to keep the interest rates high. If interest rates fall, foreign investors can take their money out and may worsen the foreign exchange crisis leading to further depreciation of rupee. 

The government's Argument 

The government was saying that the consumer price index has decreased significantly, and whatever little consumer inflation is there it is mainly due to food inflation; and that too has been coming down steadily. The government also said that the wholesale price index has not only been declining, it is in negative zone for 10 months consecutively. Yet another indicator of inflation, namely GDP deflator, figures of which have also been published recently also indicated inflation in negative zone, what we call deflation. Given the present scenario of deflation, reduction in interest rates was actually a rational policy; and therefore RBI was under tremendous pressure to revise its notes. 

Deepening confusion 

Differing figures of consumer inflation and wholesale inflation is no new phenomenon. However, it is also true that the difference is now clearly more apparent. It is expected that once the wholesale price index comes down, consumer price index would follow the suit. But now when GDP deflator was also supporting the thesis of deflation, there was no reason of confusion about the same. 

Pressure on Reserve Bank 

Although RBI was hesitating to reduce interest rates for fear of inflation, at the same time, pressure had also been mounting on (RBI Governor) Raghuram Rajan to change its attitude after retail inflation remained below the target rate of 4 % and wholesale inflation continuing in the negative zone for 10 months in a row. Now when GDP deflator was also supporting the deflation argument, majority economists believed that reduction in interest rates would be the best weapon to deal with emerging scenario. The Prime Minister's Chief Economic Advisor, Arvind Subramaniam had long been arguing for reduction in interest rates to encourage investment demand, consumer demand and housing demand. Now after the publication of figures on GDP deflator, he was arguing even strongly for reduction in interest rates. 

Deputy Chairman of NITI Aayog Arvind Pangaria also said that to deal with the current situation, 50 to 100 points (bps) reduction in interest rates is needed. Today our country can take advantage of declining prices of oil, coal, iron ore and other raw materials by reducing interest rates. 

Has the RBI done a right thing?

Given the fact that Indian economy is caught in deflation, policy prudence required that RBI reduces interest rates; to not only take the economy out of deflation, but also to encourage growth in demand, both household and investment, including housing demand. In essence, there was nothing wrong in expecting from RBI to reduce interest rates by 100 points in next two months. Also when US’s Federal Reserve has chosen not to raise interest rates, pressure was on RBI is mounting to prepare roadmap to reduce interest rates in its September Monetary Policy Review, as there was no fear now that such step may lead to outflow of foreign exchange by foreign investors.