The decision of the Reserve Bank of India [RBI] in the bi-monthly monetary policy review on June 6, 2018 to increase the repo rate/the policy rate [rate at which the RBI lends money to commercial banks] from existing 6.0% to 6.25% has led to widespread disappointment especially from the industry and trade.
In 2016, the union government had put in place an institutionalized framework viz. the Monetary Policy Committee [MPC] to formulate the monetary policy and determine the key interest rates. The committee consists of six members drawn from different fields including the governor, RBI who is also its 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 dispensation.
But, ALAS, things on the ground have not shown much improvement even as the decisions of MPC are anomalous and out of sync with 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 target range of 4% [+/-2%] on either side in the medium-term. At the outset, the connection between interest rate and inflation especially from 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, 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 extant 6.5% to 6.25%, in the second review [announced on December 7, 2016], however 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.
Going forward, despite the inflation continuing its downward trajectory 3.4% in December, 2016 and further down to 3.2% in January, 2017, the committee kept the rate unchanged at 6.25% in February, 2017 review. During 2017-18, CPI was 2.0-3.5% 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 i.e. August 2017 review, the rate was reduced to 6.0%
During the current fiscal, even as there was no change in the first bi-monthly review [April, 2018], in the second review there is an increase of 0.25%. This is despite inflation during the first half estimated to be 4.7-5.1% being well within the target range.
Second, the committee has bench-marked its decisions to two types of policy stances viz. ‘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 the December, 2016 review despite maintaining accommodative stance, the committee refrained from reducing the rate. In February, 2017 review, even while avoiding rate cut, it had changed its stance to ‘neutral’ and stuck to it in the April, 2017 and June 2017 reviews. In August, 2017 review however, despite continuing with neutral stance, it reduced the rate. In June 2018 review, though it has kept the stance neutral, the action is hawkish.
Third, the committee has sought to justify its actions [read: either hike or no change in the rate] in terms of a number of upside risks to inflation viz. farm loan waiver, implementation of 7th pay commission recommendations and increase in oil price etc. It is hard to fathom as to how any of the mentioned factors would trigger inflation.
A loan waiver does not put more money in the hands of the farmer. All that it does is to exempt him from paying back a portion of his pending dues. The pay commission award does put more money in the hands of employees. Here again, it is absurd to surmise that this will fuel inflation. Far from that, it will help industries hamstrung by low production [courtesy low demand] to improve their utilization rates and even go for fresh investment further 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, true re-imposition of sanctions by USA against Iran [besides continuing production cut in Venezuela] has led to a spike. However, with other members of OPEC [Organization of Petroleum Exporting Countries] willing to increase output, higher price may not sustain for long. Even so, it is difficult to comprehend as to how keeping interest rate high would help rein in the inflationary effect of higher oil price if that were to continue.
Fourth, the MPC has time and again expressed concern over the slowdown in GDP growth. For 2017-18, it had revised its forecast twice first, from 7.4% to 7.3% and then, at the end of first half to 6.7% when the disruptive effect of GST [Goods and Services Tax] introduced from July 1, 2017 became visible. In this backdrop, the monetary policy cannot be oblivious of the need to support growth.
Yet, this does not get reflected in its actions at least by way of adjustment in the policy rate. Unlike during the first four years of Modi – government’s term when growth was led by heavy capital expenditure by the state, during the current fiscal 2018-19, a big boost to private investment is needed to sustain the momentum. This calls for lower interest rate regime. But, neither the RBI nor banks are keen to extend a helping hand.
While, MPC’s obsession with inflation management [much of it is unwarranted] has prevented it from going soft on the policy rate, banks have only partially transmitted the cut. Of the 2% reduction since January 2015, the banks have passed on only up to 1.6% to borrowers by way of reduction in lending rate.
When will the RBI get over its obsession with inflation? When will it respond to the dire need for supporting growth? One can only wait and watch.