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  • 6 assumptions that influence RBI’s monetary policy

    The Reserve Bank of India announced a 0.25% cut in its key interest rate in its monetary policy review on Monday. The main reason behind this cut is that the central bank expects retail inflation to moderate to 5% and the economy to grow faster by 7.6% in 2016-17.

    Now the question is how does RBI come up with these figures? Answer: The RBI takes into account five-six factors that affect inflation and economic growth. It then measures the impact of these factors and then forms its policy.

Here’s a look at the six factors or ‘baseline assumptions’:

  • Crude Oil:

    India is a heavy importer of oil. Historically, it has amounted to one-third of its import bill. As a result, the price of oil in the international markets has a big influence on prices of goods and services in India. After all, oil is used in one way or another by all industries and consumers. A drastic rise in price usually causes a rise in inflation. The price of oil trended down since November 2015. It averaged at $50 per barrel in the second half of 2015-16. The RBI expects the price of oil to average $40 per barrel in 2016-17. This low price is not only expected to lower India’s import bill, but also reduce any price-pressure on inflation.

  • Monsoon:

    The second big factor that affects inflation in India is the monsoon. A less-than-average rainfall affects agricultural productivity. This lower supply of food grains leads to a rise in prices, i.e, food inflation. Last year, Monsoon was deficient – we received only 86% of the normal quantity in September 2015. This year, the RBI expects a normal rainfall. This is another positive. It means food inflation would remain under control in FY17. This leaves room for the RBI to cut its interest rates.

  • Rupee exchange rate:

    The value of the rupee against the dollar and other foreign currencies also affects inflation. After all, any fall in the value makes imports costlier and drives prices higher. This is why the RBI monitors the rupee’s exchange rate closely. It often intervenes in the market when the rupee depreciates or appreciates by a large degree. For 2016-17, the RBI expects the rupee to be at the same level of Rs 66/$ as in September 2015. This means that it does not expect any unwanted pressure on inflation.

  • Global growth:

    India is not completely shielded from the state of the world economy. The best example is the Global Financial Crises in 2008, which affected India’s economic growth too. This is why it is one of the factors considered by the RBI. During poor growth scenarios, central banks usually cut interest rates to stimulate demand and growth. Last year, global growth fell short of the expected 3.8%. Instead, the world economy grew at 3.4%. This year, it is expected to grow at a slightly faster pace of 3.6%.

  • Fiscal Deficit:

    The government’s finances matter to RBI. If the government spends more than it earns, it runs a fiscal deficit which is financed through borrowing from the RBI and the market, which often leads to higher inflation. This year’s Budget stated that the government would stick to its earlier fiscal deficit target of 3.5% of GDP. A lower fiscal deficit gives the RBI room to announce a cut in interest rates.

  • Other factors:

    The above five are not the only factors. To be realistic, the RBI also takes into account timely macroeconomic and socio-political factors. This is why the RBI cut only 0.25% instead of the widely expected 0.5%. It expects some pressure on inflation from the implementation of the 7th Pay Commission across states and the One Rank One Pension (OROP) for retired defence personnel. This could push inflation up by 1-1.5% in 2016-17 and 2017-18, according to the RBI.

    • If you want to understand the rationale behind the monetary policy, read the RBI document. Read more

    • Why markets should take heart from RBI’s monetary policy Read more

  • 4.2%

    The RBI aims to lower retail inflation to 4.2% levels in 2017-18. This is much lower than the 5.4% levels in 2015-16 and 5.1% expected in 2016-17. This means that prices of goods and services could rise at a slower pace going forward. If this happens, the RBI could look at further interest rate cuts.