Sticky inflation: Why is RBI refusing to cut interest rates?

Sticky inflation: Why is RBI refusing to cut interest rates?

Sub: Eco

Sec: Monetary Policy 

Context:

• The Reserve Bank of India (RBI) unveiled its latest bi-monthly monetary policy review and for the eighth time in a row RBI decided that it would not change the benchmark policy rate.

More on news:

• The repo rate was raised sharply between May 2022 and February 2023 but it has stayed stagnant at the 6.5% level since then.
• Repo rate has stayed within the so-called “comfort zone” of the RBI ,anywhere between 2% and 6% — since September 2023 and the RBI has not changed the repo rate since February 2023.
• The RBI’s policy statement predicts that inflation is likely to fall below the 4% target in the near future but that fall would only be due to temporary reasons.

What is Repo Rate and Reverse Repo rate?

• Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds.
• The repo rate is the interest rate at which the RBI lends money to commercial banks.
• Reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country.

What is the goal of RBI’s monetary policy?

• The primary goal is to maintain price stability in the economy. 
• The RBI aims to ensure that prices do not fluctuate beyond a reasonable degree. 
• This fluctuation is measured by the retail inflation rate and the rate of price rise that is faced by the average individual consumer.
• The RBI is required to target an inflation rate of 4%, which means that the general price level should go up by 4% from one year to another.

Why is the RBI not cutting interest rates?

• The retail inflation rate has been coming down closer to the 4% mark. 
• Despite keeping the repo rate consistently high, the retail inflation has not dropped to touch the 4% mark since January 2021.
• The RBI has expressed its concern over the stickiness of inflation. 
• In the first four months of 2024, the inflation rate has been10%, 5.09%, 4.85%, and 4.83%, respectively.
• The RBI does not cut the repo rate as soon as the overall inflation rate falls to (or below) the 4% target in any one month. 
• The RBI typically cuts the repo rate when it finds that economic activity needs a boost.
• India’s gross domestic product (GDP) growth rate has been surprisingly strong over the past year in particular. 
• Most economists are waiting to see how the political compulsions of a coalition government will impact the Centre’s commitment to fiscal deficit i.e. the amount of money the government intends to borrow from the market.
• Higher than anticipated fiscal deficit has implications for both inflation (if more fresh money is printed) or interest rates (if there is less money for the private sector to borrow).

What is Sticky Inflation?

• Sticky inflation refers to a phenomenon where prices do not adjust quickly to changes in supply and demand, leading to persistent inflation.
• Sticky inflation is an undesirable economic situation where there is a combination of stubbornly high inflation, (and often stagnant growth). 
• Sticky inflation is often associated with cost-push factors, i.e. factors which cause a rise in the inflation rate but also lead to lower spending and economic growth.
• A basis point is one hundredth of a percentage point.
• The federal funds rate is the rate at which banks lend balances to each other overnight.