Demonetisation may cause inflation to fall under 4 %; here’s why

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Even though demonetisation of high-value notes will impact consumption in the short run, it is expected to pull down retail inflation to below 4% in November reading from 4.2% in October, a senior finance ministry official said on Wednesday. He also said the move could give space to the monetary policy committee (MPC) to further cut interest rate in the coming months.

Besides hurting luxury items and consumer goods, cash crunch due to demonetisation could also bring down the prices of essential items, the official who didn’t wish to be named said. “We expect CPI (consumer price index) to decline further to below 4% due to demonetisation and other factors,” the official added.

The CPI-based inflation rose 4.2% year-on-year, the slowest pace of annual increase since August 2015, as prices of food items including pulses turned cheaper, according to latest government data.

The likely subdued inflation print might give room to the MPC to further cut policy interest rate by 25 basis points in December, the official said.

The MPC is scheduled to meet during December 6-7 for the next monetary policy review. In its first policy review on October 4, the newly constituted MPC cut the repo rate by 25 bps to 6.25%.

Further rate cut would act as a booster to the economy that temporarily slowed due to squeeze in demand after demonetisation, the official said. He added that there would be scope for the central bank to bring down interest rate further by 25 bps by March 31 next year.

On November 8, the Centre announced that all existing R500 and R1,000 notes would no longer be legal tender to crack down on black money holders, tax evaders and terror financiers.

According to SBI Research, demonetisation could result in inflow of about Rs 5 lakh crore deposit into the banking system. Higher liquidity would bring down deposit rates as well as lending rates of banks, analysts have said.

“This development should benefit the banking system in the form of a higher level of low-cost deposits, although this benefit may not be apparent on a near-term basis (due to likely withdrawals by people when currency supply increases),” rating agency Moody’s said on Wednesday.

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