Why hasn’t RBI cut policy rates despite its lack of control over food inflation?

The expected future earnings growth of companies is being downgraded. And the commentary being provided by the managements of consumer-oriented companies isn’t good.

Not surprisingly, calls for the Reserve Bank of India (RBI) to cut the repo rate, or the interest rate at which it lends to banks, are growing stronger. 

Once RBI cuts the repo rate, the hope is that banks will cut the interest rates at which they lend, people and businesses will borrow more and spend more, and this in turn will help the earnings of companies grow faster, thus ensuring that stock prices continue to rise at the rapid pace they have over the last few years.

Also read: Food vs core inflation: No, RBI's rate policy doesn’t need a new playbook

Now, simplistic ideas may make for great elevator pitches, but they leave out a lot of inconvenient detail. In September, inflation, as measured by the consumer price index (CPI), was 5.5%, primarily driven by higher food prices; food inflation was 9.2%. 

Food items have a weightage of a little over 39% in the items that constitute the CPI. In 2024-25 so far, food inflation has averaged 7.8%, while retail inflation has averaged 4.6%.

RBI cannot control food inflation. So, the argument is that it might as well cut the repo rate, which has been at 6.5% since February 2023. Of course, RBI knows that it cannot control food inflation. So, why is it not easing its policy?

First, RBI can control the non-food part of inflation. As former RBI governor Raghuram Rajan put it: “We can control demand for other, more discretionary items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items."

Core inflation, which excludes food, fuel and light, and petrol, diesel and other fuels for vehicles, has averaged 3.5% in 2024-25. It averaged 6.2% and 5.3% in 2022-23 and 2023-24, respectively. So, RBI has managed to control the non-food non-fuel part of inflation. If it hadn’t followed this strategy, overall retail inflation would have been higher.

Maintaining interest rates at higher levels has been one part of this strategy to control non-food non-fuel inflation. How does this help? When commercial banks lend, they do so by creating a deposit of the same amount as the loan. Hence, they create new money. The premise that deposits fund loans is wrong. Loans create deposits. In reality, deposits are a balancing factor.

Also read: Time for RBI’s mea culpa on ‘inflation is transitory’ stance

When RBI maintains interest rates at high levels, it discourages banks from lending money at a fast pace. In the process, a lower amount of new money is created than would have otherwise been the case. This leads to less money chasing goods and services, helping control the rise in prices.

Other than commercial banks creating money when they lend, RBI also creates new money. This is referred to as ‘narrow money.’ RBI has controlled the growth in narrow money over the last few years so as to control non-food non-fuel inflation. This is one reason why RBI has not been cutting the repo rate.

Second, as RBI governor Shaktikanta Das put it: “Our efforts are… to align inflation as closely as possible with the 4% target." Das’s term ends in December and he would clearly like to go out on a winning note. So, it seems highly unlikely that RBI will cut rates in 2024.

Third, the low interest rates that prevailed during the pandemic changed the saving and investing behaviour of Indian households, encouraging them to take more risk in the search of higher returns than what bank deposits offer. They now have more money invested in stocks, directly and indirectly, than was the case before the pandemic.

This has changed the constitution of deposits. When it comes to commercial banks, the percentage of deposits owned by households has gone down. Households tend to hold deposits for a longer duration than others. 

This helps banks balance their long-term loans better through long-term deposits. But with households owning a smaller proportion of deposits, the asset-liability mismatch for banks has gone up.

In this scenario, if RBI had decided to cut the repo rate, banks would have cut their lending rates. This would have forced them to cut their deposit rates as well to maintain their margins—that is the difference between the rates at which they lend and the rates at which they borrow. 

And lower interest rates would have led to more household deposits finding their way to stocks, leading to the constitution of bank deposits changing further, with short-term deposits forming a larger proportion of deposits, thus worsening the asset-liability mismatch. This is another reason why RBI hasn’t cut the repo rate.

Also read: India's inflation targeting: Base it on reality and not perceptions

One thing that has changed recently is the fact that stock prices have been falling. If they continue declining for a while, then households may no longer be as attracted to stocks as they have been during and after the pandemic. This might just allow RBI to cut the repo rate without worsening the asset-liability mismatch of banks.