For last 72 hours, most of the news headlines belonged to Urjit Patel’s resignation as Reserve Bank of India (RBI) Governor, Congress Party winning Assembly elections in Chhattisgarh, Madhya Pradesh and Rajasthan and appointment of Shashikant Das as new RBI Governor. During all this noise, one thing that didn’t get lot of attention was India’s retail inflation declined to 2.3%. This is a significant development for variety of reasons.
In 2014, at its peak inflation was at 12%. RBI as Regulator looks at Inflation as one of the key indicators while determining interest rates. As a result, inflation directly / indirectly plays a very important role in determining rate at which you and I pay interest to bank on our loan (like car/ housing). It also determines rate at which bank pays us the interest on our deposits. If you look at India’s data for last 5 years, inflation has come down from 12% to 2.3%. It had its ups and downs. But general trend has been downward.During the same time, core interest rates have come down from 8% to 6.5% (rates have gone down 2% and there has been hike of 0.5%. So net change is about 1.5% ).
Before we get into too much details about why and how inflation and interest rates are tied at the hip with each other, let’s spend few moments to understand what inflation actually means. Inflation is rate (expressed in %) at which price of a commodity or service changes over a course of time. For example; if something costs ₹ 100 today and its cost ₹ 105 a year later, inflation is 5%. General rule of thumb is as prices increase, customer needs to spend more money to buy same good / service. Net effect of inflation is reduction in spending power. A good example of this is house hold budget. For sake of simplicity let’s say I’ve ₹100 to spend on house hold things. Grocery costs me ₹30, fuel costs me another ₹5, home loan installment is ₹8 and car loan installment is ₹7. So, every month my fixed expenses are ₹ 50. Then I’ve a decided to save ₹35 various reasons. After all these are taken away, I am left with ₹15 to spend on different things.
RBI and different central banks world over have responsibility to control inflation. They use variety of tools do achieve this. Interest rates is most useful and important tool. Increase in interest rates usually lowers inflation. The rationale behind this concept is very simple. As interest rates increase, cost of credit (loan) goes up. This results in consumers having to pay more for loan and cut down on expenses. Now let’s go back to our household budget example. For sake of simplicity, let’s keep grocery expenses at ₹35 and fuel cost at ₹ 5. Due to increase in interest rates, my home loan installment has gone up from ₹10 to 13 and car loan has gone up from ₹ 8 to 10. So, my monthly expenses are at ₹ 55 (up from 50). Now, I’ve 2 options to balance my budget.
- Keep savings at ₹35, which means my total outgo is ₹90 and I am left with only ₹ 10 to spend (down from 15).
- Other option is to keep spending ₹15 and cut down savings from ₹35 to 30.
This option of tying inflation and interest rates to each other has been corner stone of monetary policy for most centrals banks in 19th and 20th century. However, as we entered 21st century and era of e-commerce retail took off, things have become complicated. Let me share couple of examples.
For my 2-year-old, I need a pack of 65 diapers every month. Retail price of this diaper pack is ₹930. Amazon offers the same at ₹642 and Flipkart offers it at ₹ 650. So, I am spending nearly ₹280 less (BTW, over last few months, we observed our neighborhood grocery store offering similar discount on diapers). This is not an isolated example. This week, my computer table broke and I was forced to order a new one. We (again) went to Amazon to place this order. The table we ordered had retail price of ₹9,000, after different discounts I had to pay ₹3,999. I saved nearly ₹5K which can be used to spend on different things.
In both cases, the discount money is still available with me to spend on different things. How does one account for this discount in overall inflation calculation? Over the years, traditional brick and mortar stores have offered discounts to encourage more sells. But e-commerce retail has taken this to a different level. It has resulted in people saving money despite their spending!
2018 saw growth of 31% in e-commerce market in India. Total sales are expected to be in region of $32 Billion. This accounts for about 3% of overall retail sales. Currently 25% of population does digital shopping. With falling prices of mobile phones and data usage, India’s e-commerce market is expected to grow 5 fold to $150 Billion in 2022. This would mean more discounts. In order to stay competitive brick and mortar stores would be forced to reduce the prices. This would have an impact on inflation for sure.
India is not the only country that’s facing this problem. This problem is giving headaches to central banks world over. Bank of Japan has kept negative interest rates to encourage spending. But their efforts are yet to show desired results due to Amazon and other online retailers. To stay competitive, brick and mortar stores are now offering discounts which is causing drop in inflation which is making this problem worse.
How central banks and their monetary policy evolves in this era of e-commerce retail remains to be seen. There is a strong case for some adjustment for sure. How soon regulators adopt and adjust would have long lasting effects for sure…