#EconomicSurvey: With Lower Inflation, Interest Rates May Dive

According to the Economic Survey 2015-16 tabled in Parliament today by Finance Minister Arun Jaitley, inflation in the current financial year remained between four per cent and six per cent. This is, in fact, a great achievement, because not long ago, inflation was in double digits. However, after reaching a near-historic low in July 2015, inflation rose every month. In January 2016, the consumer price index-based (CPI) inflation was 5.69 per cent. Even though it is lower than what it was through most of the past one decade, it is still a 17-month high. As inflation spiraled downwards till July 2015, the Reserve Bank of India (RBI) had been cutting the repurchase rate at which the central bank lends to commercial banks. In 2015, the RBI cut the repo rate by 125 basis points. Banks, too, followed suit, though the fall in interest rates was lesser than the decline in the repo rate.

Pay Commission Impact

The Seventh Pay Commission had recommended higher salaries. The Economic Survey points out that this is not likely to raise prices. Even if the salaries of the central government employees rise after the implementation of the panel, prices generally would not rise so long as the government does not finance the additional expenses by selling bonds to the banking system. To put it simply, even if salaries rise, the general price level would not rise as long as the money supply does not rise. This is because average prices are determined by the ratio between money supply and the amount of goods in the economy. When salaries of government employees rise, prices would not rise unless the money supply rises as well.

But, the housing markets may respond differently if the Seventh Pay Commission recommendations are accepted by the government. When salaries rise, more people will be able to apply for mortgage loans. When there is a greater access to mortgage loans, the cost of borrowing money to buy a house will decline. This will raise demand for housing, and subsequently, the price of housing. But, the housing and mortgage markets are just one segment of the economy. There is no reason why prices in general should rise throughout the economy.

The implementations of the Sixth Pay Commission proposals, for example, did not raise the general price level, the survey points out. The implementation of the pay commission recommendations also did not change the demand for goods in the economy much. This is because salaries payouts are only a small fraction of the spending in the economy. Even relative to government spending, the salary payouts are a small fraction. Moreover, when the government works toward lowering the fiscal deficit, inflation is likely to fall.

The inflation target of five per cent for March 2017 is not overly optimistic. At some points in 2015, inflation was even lower than four per cent.  So, it is not clear to what extent the RBI is likely to cut the repo rate in the next one year, and to what extent interest rates are likely to fall in the next financial year. But, if inflation remains consistently low for years, interest rates are likely to fall, making mortgage loans less expensive.