It is generally said that elections are won on ‘perception’ – an impression [or interpretation] based on one’s understanding of something. If, a particular party and its leader is perceived to be good then people vote for it en mass – irrespective of the situation on the ground in regard to its contribution to their welfare and economic development.
This is also true of the process of policy formulation which too is guided by impressions formed over a period of time and get assimilated in an institutional set up. The perception influences the decision making process even transcending individuals who sit at the helm. The making of monetary policy is a classic example.
Thus, for generations, there has been a sacrosanct belief that in an inflationary situation, there cannot be any room for reduction in interest rate or pumping more liquidity [money supply] in the economy. The Reserve Bank of India [RBI] cannot afford to go for ‘accommodating’ policy stance under a scenario of high inflation.
Successive governors followed this dictum and Raghuram Rajan was most vocal about it. He excelled all others by even raising the inflation bar. Thus, instead of linking policy rate [interest rate at which RBI lends money to banks] to whole sale price index [WPI], he decided to use consumer price index [CPI] as the benchmark.
Rajan’s obsession with inflation had crossed limits of ‘reasonableness’ when he did not reduce policy rate even when CPI was well within the target. He would do so by imagining that food inflation could resurrect or oil price would spike [during September, 2013 – December, 2014, his actions were hamstrung by this mindset].
Now, even as Monetary Policy Committee [MPC] – it includes three nominees from RBI and three from GOI – is in place, the legacy of previous governors remains. Rajan’s successor, Dr Urjit Patel too has been groomed in the same environment. It is therefore, unlikely that the course would change.
In the last review [August, 2016], Rajan had kept the rate unchanged citing pick up in CPI during June, 2016. Now, in view of latter declining to 5.1% in August, 2016, MPC in its review on October 4, 2016 has announced reduction in policy rate from extant 6.5% to 6.25%.
The committee deliberated over this for two days and all the 6 members voted in favor of the 0.25% reduction. It also decided to keep the cash reserve ratio [CRR] – the amount of money parked with apex bank as a percentage of bank deposits – unchanged at 4%. RBI also reiterated its commitment to provide sufficient liquidity via open market operations [OMO] to enable requisite pick up in credit.
Should one take these decisions to mean that the apex bank has abandoned the approach ingrained in this institution for decades? The answer is an emphatic ‘no’.
In its outlook accompanying the monetary policy statement, RBI has observed that “strong improvement in sowing along with supply management measures will improve the food inflation outlook”. It expects these measures “to have a moderating influence on food inflation in the months ahead”.
The committee also expects “the CPI inflation to move towards 5 per cent by March 2017, with risks tilted to the upside, although lower than seen in the second and third bi-monthly policy statements of June and August”. It is thus abundantly clear that the process of setting policy rate remains deeply entrenched in the inflation dynamics.
Luckily, currently inflation is benign courtesy, a favorable monsoon emboldening prospects of food production and good management of supplies [including pulses]. In future, if the scenario turns unfavorable leading to resurgence of food inflation, with the present mindset, it is inevitable that RBI will increase the policy rate. That won’t be good for the economy.
The standard prescription of keeping interest rate high in an inflationary situation assumes that a lower rate and more liquidity [vide more credit] would exacerbate inflation by boosting aggregate demand. This is a flawed premise. 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 predominantly a function of supply. If, there is disruption in supply then, price will rise even if the 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; the sooner, the better. The high interest rates are a major barrier to spurring growth. This is more so for small industries and businesses [including start-ups] who need funds at low rates to run their units and stay competitive as against current high rates of even up to 15% depending upon how the bank assesses them.
If, the base rate [benchmark that banks use for lending to borrowers] which is tagged to the policy rate itself is high, how will these small industries and businesses will get relief? A significant reduction in policy rate – irrespective of prevailing inflation rate – is needed to give a boost to them and thus help “Make in India” succeed.
This is also necessary 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.
RBI has often lamented that banks do not fully transmit reduction in policy rate to borrowers. The banks are not doing it largely because of high NPAs which eat up a good slice of their saving in interest cost due to lower policy rate. While, banks must rein in NPAs, the apex bank cannot use it as an excuse for not doing its part of the job.