The mechanics behind RBI rate cut

RBI announced a Repo rate cut by 25bps. The Repo Rate was reduced from 6.25% to 6% after the Monetary Policy Committee of RBI meeting, as was widely speculated before the meeting. In this post, we will try and understand the reasons behind the rate cut. To understand the reasoning, it is essential to know the relation between inflation and repo rate.

Repo rate is used by RBI to influence the short term money supply in the economy. It is the (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks. RBI uses the Repo rate as a lever to influence inflation in the country.

repo-rate-inflation
Inflation and Repo Rate (Source)

Inflation is a lagging indicator in response to the repo rate changes. The inflation rate typically reacts inversely changes in the repo rate.

If the inflation rate is higher than the limits targeted by  RBI, the RBI looks to increase the repo rate so as to encourage banks to increase the lending rates/savings rate for its customers. This, in turn, encourages the customers to consume less and save more. Similarly, when the prices are stable over time, RBI sometimes decreases repo rate to encourage private investments and thus help in increase in growth rate of GDP.

Since 2016, RBI has embraced inflation targeting as an official policy, in collaboration with Ministry of Finance. The RBI and the Government, have decided the inflation target between 5th August 2016 to March 31, 2021, 4% with an upper and lower limit of 6% and 2% respectively. In fact, the Monetary Policy Committee would be entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.

India has been going through a period of historically low inflation. The latest CPI numbers released for June 2017 show that YOY inflation went to 1.54%, much below the target lower rate of 2%. Prices of food and beverages have been under deflation since May 2017, with YoY growth going to -1.1% in June. It is worth noting that the infamously expensive pulses have gone back to their price levels of June 2015, after recording a massive drop of 22% YoY.

While disinflation has been observed over the past few month, it is not clear if it transitory or structural. A reduction in repo rate would lead to increase in prices, and RBI assesses risks of steep price rise, as well. However, with the reducing inflation trend observed in various commodities and a strong monsoon season this year, the RBI had room to reduce the Repo rate.


This article is written by Vishu Agarwal. He is a policy enthusiast who follows India’s economic and monetary policies very closely.

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