Inflation. market-rates and rate-cuts...

Inflation has been a dominant story in INDIA since the last years of the former UPA term originated by the loose monetary and fiscal position in the hindsight of the global recession 2008 which no doubt stoked the growth rate to double-digits but also resulted in the overheating of the Indian economy on the back of the strong domestic demand. Interest-rates were cut by several points and the fiscal tap remained opened till inflation reached 20% and the supply constrained economy news hit the headlines and the RBI under Subbarao started tightening which remained tight till Raghuram Rajan and a change in the base year for inflation and growth, according to which inflation fell near target which made possible rate-cuts. Probably the IMF has appreciated the change in methodology as uptodate. However, there is still disagreement among the economists to consider the repo-rate sole determinant of real-returns on savings, because the nominal return for a one year deposit is around 8%. Most of the banks are offering eight-plus interest rate for one year deposits. Not to forget but Rajan has promised to pay a real-return on savings of 2% in a hawkish move and 1.5% being a little dovish which if we take in to account only repo rate which is 6.5% does not leave much room for rate cut. The real rates according to the present situation are lower than 1.5%, around 1.1%. But, as we have said earlier repo-rate is not the only determinant of the market rates and if we take market rates as the determinant of real-returns, market rates are around 8% and accounting for inflation leaves us with a 2.6% of real-returns. Therefore, on a practical level we have 60 to 100 basis points of room to lower nominal interest rate. Moreover, we cannot say that this is the bottom of rate-cut because we are still 6% nominal interest rate economy in a world of negative interest rates and deflation. In the last rate cut cycle the nominal interest rate was just above 4%. INDIA’s supply-side does not allow it to adopt aggressive monetary-policy, The economy easily starts inflating and it is mainly food inflation which cannot be solved by higher interest rates when credit penetration in agriculture is still very low and the main source of credit are traditional money-lenders who charge as high as 20%. Credit gap in agriculture is also a big problem. There are no facilitates for credit besides weather side and water and irrigation problems.