RBI, Inflation And Interest Rate

Last week the November inflation number came out at 5.5% - below the upper limit (6%) of the inflation target. So the media is saying that RBI must cut the interest rate. Is this view correct?

The RBI's Bulletin in July said that India's neutral/natural interest rate is around 1.5-2%. What does 'neutral/natural interest rate' mean? The top table illustrates this:

a) When the real interest rate is at the neutral/natural level, it neither decreases nor increases inflation. This is neutral monetary policy.

b) When the real interest rate is above the neutral/natural level, it decreases inflation. This is contractionary monetary policy.

c) When the real interest rate is below the neutral/natural level, it increases inflation. This is expansionary monetary policy.

Currently the inflation and interest rate situation is:

1. Inflation is 5.5% - above the target level (4%). So it must be decreased. That is - real interest rate must be above the neutral/natural level of 1.5-2%. 

2. But the repo rate is 6.5%. So the real repo rate = 6.5% - 5.5% = 1%, which is less than the neutral/natural level (1.5-2%).

3. So monetary policy is actually expansionary - ie, tending to increase inflation!

So to what level must inflation come down to justify a rate cut (in an already expansionary monetary policy)? The bottom table illustrates this. If inflation comes down to 4.5% (Case 1) then the repo rate can be cut to 6.25%. Because then the real repo rate will be 6.25% - 4.5% = 1.75%, which is above the lower limit (1.5%) of the neutral/natural level (1.5-2%) - which it has to be because inflation (4.5%) will still be above the target level (4%). Whereas inflation coming down to even 4.75% will not justify a rate cut (Case 2).

Of course, this is by taking the lower limit (1.5%) of the neutral/natural interest rate (1.5-2%). If we take the upper limit (2%) then inflation has to come down all the way to its target level (4%) to justify a rate cut (Case 3). Even inflation coming down to 4.25% will not justify a rate cut in this scenario (Case 4).

Low Salaries: Law Of Demand And Supply

The internet has many posts criticising the low salaries for:

1. Assistant Professors (like ₹ 35,000/month) in many colleges and universities

2. Fresh engineers (like ₹ 3 lakh/year) in companies like TCS, Wipro and Infosys

Wage is the price of labour. And the most fundamental law of economics is that all prices are decided by demand and supply. High demand or/and low supply leads to a high price/wage. And low demand or/and high supply leads to a low price/wage. Low salaries for Assistant Professors and fresh engineers are simply a reflection of the high supply of these workers.

The average wage of a casual labourer (like farm workers and construction workers) in India is ₹ 400/day. So if a farm/construction worker works 30 days a month, he/she will earn only ₹ 12,000/month - for doing back-breaking work in the hot sun the whole day. Is this fair? Of course, it is not. But the world does not run on fairness - it runs on the laws of economics, especially the law of demand and supply . . .