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).