The debate on rate cuts
have been going on in the media, as always happened prior to RBI’s policy announcement. Expectedly, two views emerge. While
economists of the business houses unilaterally argue for a rate cut, academic
economists, though justified, are divided over the issue. First, some
ground realities. Inflation, both actual and expected, stays high much beyond
the comfort level. IIP is in a freefall! Growth rate of GDP has been shrinking.
Gross fixed capital formation has also declined. Household savings rate is also
declining. Central banks around the world, notably the Fed’s QE3, are going for
accommodating policies. Interest rate cost of investment has gone up.
Government has adopted some policy measure to rein in fiscal deficit. These
diverging trends may pose serious challenge for the RBI to conduct its monetary
policy that is further burdened by market expectations and frequent
communications from the finance ministry.
It seems that the RBI
now stands between two paradoxes. Cutting policy rates would hardly stimulate
investment, as policy paralysis has much to account for this depressed
investment. On the other hand, RBI has hardly been successful in taming
inflation in its two and half year’s battle. Inflation,
measured by month-on-month, is 7.8% in September, the highest in this year.
More importantly, inflation is over 7% in a row for last 34 months staring December
2009. Assuming that it takes at least six months for interest rates to have
complete impact, average inflation still stands at 8.7% for the next 21 months,
thus defying RBI’s commands. Hence, there is hardly
any justification in keeping policy rates high.
The
findings of 28th round of inflation expectations survey of households
for the first quarter of 2012 reveal that the percentage of respondents
expecting price rise in next three-month and in next one-year have gone up.
There has been a marginal increase of 30 basis points (henceforth, bps) as
compared with the last round of the survey for the three month ahead and
one-year ahead mean inflation expectations that stay at 12.0% and 12.8%,
respectively. More importantly, 44.5% of the respondents think that RBI is ‘not’
taking right action against inflation while 43.5% feel that it is doing the
right work. It does not show RBI has earned any credibility. Neither has RBI been
successful in reducing inflation to its comfort zone nor has it helped reduce
inflationary expectations.
RBI has hiked repo
rates 13 times since March 2010. Many economists believe that this baby-step
rise in repo rates has not been successful in dampening inflation. Similarly, both
RBI’s surprised repo cut of 50 bps and CRR cut of 25 bps have
also not helped much, as evident from the frozen IIP numbers and reducing
forecast of growth.
Pursuing
such a high interest rate regime for a long period might turn out to be
counter-productive. As we know theoretically that when industrial prices are
cost determined firms will pass these rise in costs in terms of higher
manufacturing prices. And there has been evidence that the interest cost as a
share of total cost is non-trivial. In fact, industrial price is very highly
correlated with WPI inflation. Further, it may dent that part of agricultural
investment and agricultural growth which depends upon formal credit. Hence, on
both accounts, a high interest rate would be costlier to both farm sector and
firm sector.
The fact that
government has shown some seriousness through recent policy announcements and
is doing its bit, it is a best chance for the RBI to have an unexpected larger
cut. Increasing basing monetary policy on fiscal
consolidation may not always yield the optimal outcome. High interest rate
regime has contributed to one-third of the slowdown. But this is not a non-trivial
magnitude!
While
most debates have surrounded whether to reduce rates, less attention has been
given on the magnitude. RBI should go for a bigger cut. It would help test if
the baby-step hypothesis, pursued by the RBI, was right. In other words, if a
steep repo rate cut of 1 percentage point or simultaneously reducing repo and
CRR would boost investment, then we can say that piece-meal approach of the
central bank won’t help much as compared to “athletic-steps”. Further, it would be a
good test to measure the effectiveness of central bank policies in the face of
supply-side led inflation.
RBI’s
shift from inflation fight to stimulating growth won’t signal that it has lost
the battle or nor it would signal that it is shifting its ‘inflation tolerance
level’, as certain columnists have argued. Instead, RBI can clearly communicate
to people why it reduces policy rates and how it can have an impact on
productivity that would address supply side bottlenecks. Central Banks around
the world has hardly been successful in curbing inflation led by supply side
factors. But this does not mean that it should not fight inflation at al. But, 24
months are enough to judge the efficacy of these elevated policy rates. Hence,
it merits for a somewhat bigger cut, enough to stimulating the frozen
industrial sector, and reviving growth. Finally, industrial recovery can revive
the household financial savings. The decline in household financial savings
rate may be attributed to expected low return from industrial sector and
falling IIP
numbers. Hence, they want to invest low and, save low. To
prevent this RBI can launch inflation-indexed gold bonds
It
would be interesting to see if the RBI is going for a bigger rate cut. But my
haunch is that it would either maintain the status-quo or repo cut of 25 bps or
CRR cut of 50bps. No More baby-steps Please!
Time for the RBI to go for “athletic-steps”.
