The decision of the Reserve Bank of India (RBI) last month to increase the repo rate or the policy rate (the rate at which the RBI lends money to commercial banks) from 6% to 6.25% has led to widespread disappointment, especially in industry and trade circles.
In 2016, the union government had put in place an institutionalised framework, the Monetary Policy Committee (MPC), to formulate monetary policy and determine the key interest rates. The committee consists of six members drawn from different fields, including the RBI governor, who is also the MPC’s chairperson. With this, the process was expected to become more informed and objective — free from the idiosyncrasies of the governor, who had the sole authority under the previous system.
But there has not been much improvement, as decisions of the MPC are anomalous and completely out of sync with the principles laid down by itself.
First, the committee is expected to fix the policy rate in such a manner as to maintain inflation — as represented by the consumer price index (CPI) — within the target range of 4% (+/-2%) in the medium-term. At the outset, the connection between interest rate and inflation, especially from the demand side, is tenuous.
A reduction in interest rate need not exacerbate inflation, which is affected by other factors, too. About 50% of CPI includes food items. It would be fallacious to argue that cheap credit will prompt people to increase their demand. The inflation in food is mainly a function of supply. If there is disruption in supply, then the 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.
That apart, it is ironic that despite inflation remaining within the target range, the committee refrained from affecting reduction in the policy rate. Though in the first policy review announced on October 4, 2016, it reduced the rate from 6.5% to 6.25%, in the second review two months later, it kept the rate unchanged at 6.25%. This was despite inflation remaining low at 4.2% in October 2016, and 3.6% in November 2016.
Despite inflation continuing its downward trajectory to 3.4% in December 2016 and further down to 3.2% in January 2017, the committee kept the rate unchanged at 6.25% in the February 2017 review. During 2017-18, CPI was 2-3.5% during the first half whereas during the second half, it was 4.2-4.6% — well within the target range. Yet, during that period, only once, in the August 2017 review, the rate was reduced to 6%
During the current fiscal, even as there was no change in the April review, in June, interest rate rose by 0.25%. This is despite inflation during the first half estimated to be 4.7-5.1%.
Second, the committee has benchmarked its decisions to two types of policy stances, ‘accommodative’ and ‘neutral’. While ‘accommodative’ stance points towards cut in the rate, a ‘neutral’ stance carries with it the possibility of both reduction as well as increase. It also connotes no change. Ironically, the actual movement in the policy rate has been out of sync with the stated stance.
For instance, in December 2016, despite maintaining ‘accommodative’ stance, the committee refrained from reducing the rate. In February 2017, even while avoiding rate cut, it changed its stance to ‘neutral’, and stuck to it in April and June 2017 reviews. In the June 2018 review, though it has kept the stance neutral, the action is hawkish — rise in interest rate.
Upside risks to inflation
Third, the committee has sought to justify its actions (either hike or no change in
the rate) in terms of a number of upside risks to inflation, namely farm loan waivers, implementation of seventh pay commission recommendations and increase in oil price, etc. It is hard to fathom as to how any of these factors would trigger inflation.
A loan waiver does not put more money in the hands of farmers. The pay commission award does increase cash with employees. But it is absurd to surmise that this will fuel inflation. Instead, it will help industries hamstrung by low demand to improve their utilisation rates and even go for fresh investment, propelling growth. Any impact on food prices is ruled out as demand for such items is limited by consumer’s needs/diet constraints.
As regards oil price, re-imposition of sanctions by the US against Iran (besides continuing production cut in Venezuela) led to a spike, with crude reaching $80 per barrel early this month, though it has fallen to $75 a barrel since. However, in view of oil producing countries now agreeing to pump a million barrels more per day into the global supply pool, even this level may not sustain for long. The Centre expects oil price to fall below $70 per barrel.
It is difficult to comprehend as to how keeping interest rates high would help rein in the inflationary effect of higher oil price even if that were to continue.
Fourth, the MPC has time and again expressed concern over the slowdown in GDP growth. Yet, this does not get reflected in its actions. Unlike during the first four years of the Modi government’s term, when growth was led by heavy capital expenditure by the State, during the current fiscal, a big boost to private investment is needed to sustain the momentum. This calls for a lower interest rate regime. But neither the RBI nor the banks are keen to extend a helping hand.
While the MPC’s obsession with inflation management has prevented it from easing the policy rate, banks have only partially transmitted the cuts so far. Of the 2% reduction since January 2015, banks have passed on only up to 1.6% to borrowers.
When will RBI shed its infatuation with inflation? When will it respond to the dire need to support growth? When will banks follow suit? One can only wait and watch.
(The writer is a New Delhi-based policy analyst)
https://www.deccanherald.com/opinion/panorama/rbi-has-put-growth-backburner-680132.html