In the first monetary policy review under MPC [Monetary Policy Committee] dispensation announced on October 4, 2016, the RBI governor, Dr Urjit Patel took an accommodative stance [euphemism for ease of money supply and low interest rate] and demonstrated this by reducing policy rate [interest rate at which apex bank lends to banks] by 0.25% from extant 6.5% to 6.25%.
In the second review announced on December 7, 2016, Dr Patel maintained the accommodative stance but did not translate the intent in to action as the policy rate was kept unchanged at 6.25%. This was despite inflation as measured by consumer price index [CPI] continuing its downward trajectory to 4.2% in October, 2016 and 3.63% in November, 2016.
Now, in the third review announced early this month, he has changed the stance from accommodative to ‘neutral’ and kept the policy rate unchanged at 6.25%. A neutral stance implies that the rate won’t just remain unchanged but also there is a possibility of it being increased. By any stretch of imagination, this is untenable.
The stance cannot be justified even within the limited confines of the criteria set by RBI viz. inflation. Even after November, 2016, CPI has continued its downward journey. It was down to 3.4% in December, 2016 and further declined to 3.2% in January, 2017. This is well below 5% target for period ending March 31, 2017 as well as medium-term target of 4% [+/- 2%] up to 2021.
RBI perceives three factors as major risk viz. (i) decision of US Federal Reserve Board [FRB] to affect more hikes in rate during 2017 [on top of 0.25% hike in November, 2016] (ii) increase in price of crude oil and (iii) upward risk to food prices. The concerns are out of sync with the ground realities.
First, increase in fed rate may increase risk of capital outflow from emerging market economies. But, any inference that funds will leave India on this basis alone would be far-fetched. The real driver of foreign funds inflow is confidence in economy, ease of doing business and pace of reforms wherein India has a high score. Further, demonetization will help the economy to emerge stronger from 2017-18 onward. Hence, there is no risk of funds moving out.
Second, the expectation that price of crude oil will be on a rising trajectory is based on the decision of OPEC [organization of petroleum exporting countries] as well as non-OPEC countries [Russia, Nigeria, Venezuela etc] to affect a cut in production from January, 2017. But, this does not take into account the effect of increase in US shale oil production. On balance, it is unlikely that oil price will go beyond US$ 65 per barrel.
Third, in monetary policy statement accompanying October 4, 2016 review, RBI had 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”. Things are happening on ground as expected which is corroborated by low CPI in December/January enabled primarily by decline in food prices.
In the past, a major factor behind food inflation used to be hoarding funded by cash – primarily black money. The hoarders invariably exploited supply shortage in sensitive commodities to jack up prices. Now, with Modi – government making a frontal attack on black money [demonetization of 500/1000 rupee notes announced on November 8, 2016 was a major step in that direction], henceforth, inflationary situation will turn benign.
Another major factor contributing to inflation is the cascading effect of taxes and duties [at central and state level] as also high transaction cost associated with cumbersome procedures for their administration. In this backdrop, introduction of GST [Goods and Services Tax] from July, 2017 will make a big dent on inflation by eliminating the cascading effect and reduction of transaction cost.
The interest rate is not a potent factor in influencing inflation. The latter is primarily 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. Therefore, it won’t be prudent for RBI to be guided solely by movement in inflation while deciding on the interest rate policy.
Buttressing his case for no rate cut, the governor also argued that thus far, banks have been laggards in transmitting reduction in policy rate made since January, 2015. As against a cumulative cut of 1.75%, they have reduced lending rate only by 0.8% – 0.9%. Hence, he argues, there is a case for banks to do more to achieve full transmission. But, that cannot be a valid basis for the apex bank not to do its bit.
Ironically, RBI has got so much obsessed with inflation–interest nexus that it has little time to attend to dire need for supporting growth impulses unleashed by Team Modi. The latter has done a lot to improve ease of doing business and create a conducive environment for giving a fillip to small and medium enterprises [SMEs] and start-ups including by giving fiscal incentives.
The government is also giving a big boost to infrastructure projects viz. roads, rails, power, port etc a fundamental requirement for putting the economy on a high growth trajectory and make our products and services competitive both in the domestic and export markets. It is giving equal emphasis to building social infrastructure viz. homes, schools, colleges, hospitals etc for people’s welfare and improving their quality of life.
These efforts will fail to yield the desired results if banks do not make commensurate efforts to make credit available at low interest rate. There is absolutely no valid basis for the RBI and commercial banks not responding in required measure especially when they have surfeit of cash, courtesy demonetization [over Rs 1300,000 crores cash embedded in 1000/500 notes has come back].
During his earlier stint as deputy governor under the then, RBI chief, Dr Raghuram Rajan, Dr Patel was better known as ‘inflation warrior’. He needs to come out of that shadow and focus on using interest rate as an instrument of spurring growth leaving inflation management to the government. Hopefully, he will heed in next review.