The Disconnect: Real rates, unreal times – The Economic Times

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Synopsis–Someone has to pay the price to keep the wheels moving — so that one day the sputtering engine of growth starts roaring.

Mumbai: Someone has to pay the price to keep the wheels moving — so that one day the sputtering engine of growth starts roaring. Today, that burden is on the drooping shoulders of pensioners and families who depend on shrinking interest income from fixed deposits lying with banks. They may have to live with that pain for a year, or even longer in a milieu of low interest rates.

Gainers, Loses
Who gains and who loses out when interest rates in the economy are kept low and financial markets are awash with money pumped in by RBI? The biggest gainers are the 50-odd large companies with good credit ratings: they add to the bottom-line by continually raising cheaper money with every dip in bond yields to repay older loans and lower interest outgo. Next is the sovereign whose borrowing cost is managed better with benign interest rates. Small businesses struggling to keep their heads above water may live another day to fight while softer rates on home and two-wheeler loans can tempt those inclined to spend.

Stacked against them are those relying on returns from bank FDs. These are people whose earnings, adjusted against inflation, have been negative for quite some time. They are the biggest losers of a low interest rate regime and there is very little chance that the odds will change in their favour soon. Why?

Faced with a wide destruction of demand, low growth, and anecdotal evidence of joblessness and pain in the informal sector, there is no way RBI will raise interest rates simply because the April wholesale price index (WPI) at 10.5% is the highest since 2012. It would certainly not cut rates — neither can it be justified nor is there a room left for it.

Nature of Inflation
Any central bank raises rates to discourage consumption and investment — neither of which is happening. Despite inflation, savings have risen as households are consuming less: petrol prices are up, but who is going for a long ride; prices of many items have increased, but few are buying. So, underlying the inflation number there is very little demand — making the inflation rate more symbolic and less meaningful than what it reflects in normal times.

It doesn’t mean absolute prices haven’t gone up. They have since last year amid supply disruptions. MRPs rarely come down once they go up. Indeed, the reason behind the recent dip in the consumer price index (CPI) to 4.29% (from 5.52 in March) was a drop in vegetable inflation — and not due to fuel, clothing, footwear or housing inflation which are actually high.

Like the regular shopper who knows that vegetable prices aren’t down, any trader in the bond market is aware that inflation is real — even though it’s fueled by supply constraints and not a surge in demand. There is a constant staring-out game between RBI (which wants to keep interest rates and the yield on the bellwether government bond low) and the market (which thinks that at some point RBI will drop the ball and the unsustainable low yields against high inflation will start rising.)

With inflation hardening, the tussle between RBI and the market will go on. But, in the middle of a second wave of the pandemic, RBI may be left with no choice but to effectively communicate to signal a period of ‘long, long pause’ — when it will neither cut nor raise rates.

Indeed, the central government, like the central bank, may choose a similar course — albeit for different reasons. Having dramatically rolled back a cut in small savings rate in April, New Delhi may find it politically tougher to lower the rates in June. Like RBI, the government too may prefer a pause this year.

Purists in the market will have questions: For how long can there be disconnect between (rising inflation) and (low) interest rates? Won’t such mispricing of capital and distortions create asset bubbles — like the retail rush behind a soaring Sensex? Valid questions, but may be ignored for now. Like the pensioner, the purist too will have to wait.

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