In the first monetary policy review under the MPC [Monetary Policy Committee] dispensation announced on October 4, 2016, the governor, Urjit Patel had reduced the policy rate [interest rate at which RBI lends money to commercial banks] by 0.25%. He had then, maintained an ‘accommodative’ policy stance thereby alluding to apex bank intent for reducing it further.
However, in the second policy review announced on December 7, 2016, Patel has dashed this hope by keeping the repo rate unchanged. Concurrently, he has also revised downwards its earlier estimate of GDP for 2016-17 from 7.6% to 7.1% now factoring in the effect of demonetization of 1000/500 currency notes announced by prime minister on November 8, 2016.
Put together, the two statements are anomalous. At a time when putting India on to a high growth trajectory is a dire necessity [to create jobs and increase income], the apex bank’s own assessment of significant decline in GDP growth should have led it to consider reduction in interest rate. Yet, it has decided to keep it unchanged.
The contradiction in RBI’s approach can be seen from another angle. As in October, this time also, Patel insists that ‘the policy stance continues to be accommodative’. If, that is the real intent, then, this ought to have got reflected in his actions. Why has he refrained from bringing about further reduction as hinted in October?
The irony is very much like his predecessor [Rajan], the present governor too sees interest rate as a potent [perhaps, the only] instrument of reining in inflation. This is not unexpected as in his earlier incarnation as deputy governor under Rajan, he became popular as ‘inflation warrior’ being part and parcel of latter’s hawkish approach.
Team Rajan/Patel was overly conservative in its approach. It did not reduce policy rate despite consumer price index [CPI] showing signs of easing during second half of 2014. From January, 2015 till April, 2016, it conceded a cut of 1.5% [from 8% to 6.5%] despite a drastic drop in CPI. In the policy reviews in June, 2016, and August, 2016, the rate was kept unchanged.
Rajan did not even follow his own benchmark. Patel looks no different. In December policy review, he has not reduced the rate. This is despite CPI decreasing to 4.2% during October, 2016 [led mainly by food which fell by 3.32%] and further down to 3.63% in November. Pertinently, these numbers are well within the 5% target set for quarter ending March, 2017 and medium-term target of 4% [+/- 2%].
In support of his decision, Patel has cited global uncertainties, financial turbulence, likely increase in federal [or fed in short] rate by USA, expectation of increase in price of food and oil. The first two factors have existed all through including the period when policy rate was reduced [January, 2015 till April, 2016].
As regards food price, in monetary policy statement accompanying October 4, 2016 review, RBI observed that “strong improvement in sowing along with supply management measures will improve the food inflation outlook”. It expected “a moderating influence on food inflation in the months ahead”.
Since then, the only development is demonetization [November 8]. Contrary to much hype in the media about its likely impact on agriculture, sowing during current rabi is higher than last year’s rabi season. Therefore, food production and food price scenario is unlikely to change [albeit] for the worse.
With regard to fed rate, with unemployment reaching a record low and a pretty high pace of job accretion, chances of a hike this time around are real. This together with strengthening dollar against rupee may increase the risk of capital outflow. But, to infer on this basis alone that funds will move out of India is far-fetched.
The real driver of foreign funds inflow is confidence in Indian economy, ease of doing business and pace of reforms. In all these areas, the rating agencies have given full marks to present government. Even the decision to demonetize has been hailed as a step forward in pushing the reforms agenda. This will ensure that even after fed rate hike, foreign investors will stay invested in India.
Clearly, none of the factors mentioned by RBI were so compelling as to disallow a rate reduction. It is simply the ‘fear’ of inflation that haunts men at the helm in apex bank. They do not even bother to introspect that the connection between interest rate and inflation especially from demand side is very weak.
They merely proceed on a premise that any reduction in interest rate would exacerbate inflation by boosting aggregate demand. This is flawed. Nearly 50% of CPI includes food items. It would be fallacious to argue that easy and cheap credit will prompt people to increase their demand or stock them.
The inflation in food is mainly a function of supply. If, there is disruption in supply then, price will rise even if interest rate is high. On the other hand, if supply is managed well then, inflation can be tamed even with low interest rate. Clearly, interest rate is not a deterrent and it has no role in inflation management. MPC should come out of this flawed inflation-interest nexus.
Instead, the committee should seriously think through as to how monetary policy can be galvanized to spur growth. Keeping interest rate low is very crucial to give a boost to small and medium enterprises [SMEs] including start-ups. Until hitherto, majority of SMEs were cash driven and hence, they have been battered the most by demonetization. In this backdrop, lower rate on loans will be a great help.
Lower rate is also needed to improve the viability of infrastructure projects viz., roads, rails, power, port etc and enable them provide utilities and services at competitive tariffs/price. It will also help reduce the interest subsidy that banks give to keep the cost of credit to farmers low. It will enhance the competitiveness of our exports.
At present, banks are flushed with funds [already, in the follow up to scrapping of 1000/500 notes, they have got deposits worth Rs 1250,000 crores] and a lot of these would remain in low cost saving and C/A . This will enable them to reduce cost of funds. But, RBI should not use this as an alibi for avoiding any cut in the policy rate.