RBI in India for instance, will regularly communicate its analysis of existing inflation trends and its expected future trajectory - food basket prices, liquidity situation, credit and deposit growth etc. with the market. This is done to reduce the gap between the view of RBI and what every individual and corporate’s calculation and expectation of inflation is.
Also, inflation expectations feed into future inflation. For example, if you as an employee know (from RBI releases) what inflation trend is going to be in a particular year, you would plan to negotiate a better than inflation salary hike (or work towards it) during your annual appraisal and your employer may try to protect his margins (profits) by getting more work out of you and/or raising the price of the product/service he's selling. This series of events will eventually increase the inflation.
On the other hand, if people expect future inflation to be low, they will postpone their consumption (or purchase) and hence affect demand which will lead to lower prices and lower inflation or deflation.
The other implicit role of RBI is to foster monetary and financial stability conducive to sustainable economic growth.
Now, in the battle between growth and inflation, RBI is at crossroads.
On one hand, pro-growth economists argue that inflation is now at a subdued level and ground is now set for reduction in prevailing interest rates to stimulate investments and growth in the economy.
On the other hand, critics of this camp argue that the fight against inflation is not yet over and the respite is a temporary one.
Whether to cut interest rates or not - remains a tough call to make.
Interest rates are function of demand and supply of money in the market. When the supply of money is higher than the demand, price of money i.e. interest rates fall and vice versa. So, a sure way to reduce interest rates is to increase the supply of money in the market and that is what we have seen happening in developed economies of US (Quantitative Easing, or QE), Europe (rate cuts by ECB) and Japan (Abenomics) recently.
These developed economies are trying to stimulate their economies by infusing liquidity into the system. All these stimulus programs normally run a four step course:
a. A central bank infuses liquidity, typically by lowering the money market interest rates. Or it buys treasury/corporate bonds, raising their prices and hence lowering the yields and cost of funds in the markets.
b. The easing leads to a steepening of the yield curve, benefiting bank margins and enhancing their willingness and capability to lend.
c. Businesses and consumers respond to the lower borrowing costs by raising capital to expand and increase their activities.
d. ..which ultimately leads to rebound in economic growth and other macro indicators.
Luckily, Indian central bank does not have to go through all this pain to stimulate the markets.
When RBI is grappling with dilemma of whether to cut or not, market has slowly and steadily done what it does best - reconciling reality to the expectations.
Increasing foreign fund flows in the Indian markets (equity and debt) have led to excessive liquidity in the system which has led to lowering of cost of borrowing for Indian corporates.
According to recent news reports, firms have been using more commercial paper than bank credit for their short term capital requirements. The reason is simple.
Money market rates have fallen sharply, and are trending below lending rates offered by banks. This effect can be seen from the following chart where 10 days moving call money average has fallen below repo rates and have stayed there for most of 2014.
Repo rate is what banks pay to central bank for the money they have borrowed in the event of any shortfall in funds.
Moreover, banks being flush with liquidity are facing a rare situation of bulk deposit rates falling below retail deposit rates. The minimum historical spread of 1% has now fallen to negative 25bps.
So, when banks can get cheaper funds from corporates, why to pay retail customer more. So, they have now started cutting their deposit rates which will eventually lead to fall in lending rates.
Not to mention, bond prices have already started reflecting a rate cut in Dec 2 RBI meeting as yields on benchmark 10-year bond has been continuously falling.
Lower-than-expected inflation data and tumbling global commodity prices have led to a belief in the bond markets that the Reserve Bank of India (RBI) will soften its stance on interest rates at the next policy review on Dec 2. This may be followed up by a rate cut at the start of the next fiscal year, according to several traders and bank treasurers.
All this is happening without RBI intervention.
So, the bottomline is rates are coming down, whether RBI decides to cut key lending rates or not. RBI's decision on rates on Dec 2 will however, tell us where are we in our battle against inflation.