In the bi-monthly monetary policy review announced on June 6, 2019, the Reserve Bank of India [RBI] has reduced the repo rate/the policy rate [rate at which the RBI lends money to commercial banks] from subsisting 6.0% to 5.75%. Seen in juxtaposition with reduction of 0.25% each notified in the previous two reviews [February and April 2019], the banking regulator has thus brought about a cut of 0.75% in a span of less than six months.
In yet another significant move, the apex ban has changed its policy stance from hitherto ‘neutral’ to ‘accommodative’. Whereas, a neutral stance carries with it the possibility of reduction as well as increase [it may even connote no change], an accommodative stance can only mean a rate cut in the future reviews.
That the above decisions represent the unanimous view of all members of the Monetary Policy Committee [MPC] – as informed by the governor, Shashikanta Das during his press briefing – adds weight to the above decisions and reinforces the assessment that the interest rate henceforth will be on a downward trajectory.
It is good to see the apex bank showing a sense of accommodation to the concerns of the industry and trade on growth which has shown some deceleration [during 2018-19, it was on declining trajectory from the second quarter onward and plummeted to a low of 5.8% in the 4th quarter ending March 31, 2019]. This is in contrast to its intransigent attitude under similar circumstances in the past.
During the four and a half years of Modi 1.0, despite inflation as represented by the consumer price index [CPI] remaining within target range of 4% [+/-2%] on either side, the RBI refrained from making any positive moves to lower the policy rate.
Prior to January 2015, the RBI under then governor Raghuram Rajan had kept a hawkish policy when the interest rate had reached a high of 8.0%. Thereafter, even as the government succeeded in bringing down the inflation to a low of 4.2% in October, 2016, the policy rate was lowered to 6.5% [of the 1.5% cut during that period, the banks transmitted only up to 2/3rd to the borrowers].
In his first policy review on October 4, 2016, Urjit Patel [who took over from Rajan], reduced the rate from the then prevailing 6.5% to 6.25%. However, in the second review [December, 2016], he kept the rate unchanged at 6.25% despite low inflation at 3.6% in November, 2016. In February, 2017 review too, it was kept unchanged even as the CPI continued its downward trajectory to 3.4% in December, 2016 and further down to 3.2% in January, 2017
During 2017-18, the inflation was 2.0-3.5% in the first half and 4.2-4.6% during the second half – well within the target range. Yet, during that period, only once i.e. August 2017 review, the rate was reduced to 6.0%. During the first half of 2018-19, the rate was upped by 0.5% in two rounds – 0.25% each in June 2018 and August 2018 respectively. This was despite inflation during the first half at 4.7-5.1% – though slightly higher than last year but was well within the permissible 6% on the upper side of the band.
The above trend – prior to 2019 – point towards the obsession of RBI/MPC with inflation management. Or else, how does one explain its unwillingness to go soft on the policy rate even when the inflation was well within the range set by none other than the bank itself. In fact, in a bid to lend some legitimacy to what it did, it even erected a facade of inflationary expectations which was not warranted.
Here, it needs to be recognized that the relationship between inflation and interest rate is tenuous. To understand this, let us assume that inflation is higher than the target range. Going by MPC logic, the policy rate should be increased. Will that help in reining in inflation? The answer is an emphatic no.
About 50% of CPI includes food items. It would be fallacious to argue that higher cost of credit will prompt people to reduce their demand. The inflation in food is mainly a function of supply. If, there is disruption in supply then, price will rise irrespective of whether the interest rate is low or high. On the other hand, if supply is managed well then, inflation can be tamed even with low interest rate. The same logic applies even to non-food items, though to a lesser extent.
Likewise, if inflation rises due to increase in international price of crude oil [India sources about 83% of its requirement from import], there is little that a hard interest rate policy can do to mitigate its effect. The only it can be done is to increase domestic production thereby reducing dependence on import.
The message is loud and clear. The RBI should avoid being glued to targeting inflation all the time. Instead, interest rate policy should be dovetailed to propel growth. If, the rate is lowered alongside pumping liquidity in the system, this will help industries and services hamstrung by low demand to improve their utilization rates and even go for fresh investment giving a boost to growth.
Unlike during the first four and a half years of Modi – government’s first term when growth was led by heavy state capital expenditure, now, a big boost to private investment is needed to sustain the momentum. This calls for lower interest rate regime. The present governor, Shashikanta Das has done well by recognizing this and even handing out a cut of 0.75% in less than 6 months and promises more by committing to a change of stance to ‘accommodative’.
Hopefully, this momentum will be sustained.