Rajan's legacy continues

Much like his predecessor, RBI Governor Urjit Patel too sees interest rate as a potent instrument of reining in inflation.

In the first monetary policy review under the Monetary Policy Committee (MPC) dispensation announced on October 4, 2016, Reserve Bank of India Governor Urjit Patel had reduced the policy rate (interest rate at which RBI lends money to commercial banks) by 0.25%. He had then maintained an ‘accommodative’ policy stance thereby alluding to apex bank intent for reducing it further.

However, in the second policy review announced on December 7, Patel has dashed this hope by keeping the repo rate unchanged. Concurrently, he has also revised downwards its earlier estimate of GDP for 2016-17 from 7.6% to 7.1% now factoring in the effect of demonetisation of Rs 1,000 and Rs 500 notes announced by the prime minister on November 8.

Read together, the two statements are anomalous. At a time when putting India on to a high growth trajectory is a dire necessity (to create jobs and increase income), the apex bank’s own assessment of significant decline in GDP growth should have led it to consider reduction in interest rate. Yet, it has decided to keep it unchanged. The irony is that very much like his predecessor (Raghuram Rajan), Patel too sees interest rate as a potent instrument of reining in inflation. This is not unexpected as in his earlier incarnation as deputy governor under Rajan — he became popular as ‘inflation warrior’ being part and parcel of latter’s hawkish approach.

Team Rajan/Patel was overly conservative in its approach. It did not reduce policy rate despite consumer price index (CPI) showing signs of easing during second half of 2014. From January 2015, till April 2016, it conceded a cut of only 1.5% (from 8% to 6.5%) despite a drastic drop in CPI. In the policy reviews in June 2016, and August 2016, the rate was kept unchanged.

In December 2016 policy review also, Patel has not reduced the rate despite CPI decreasing to 4.2% during October 2016 (led mainly by food which fell by 3.32%) and further down to 3.63% in November 2016. Pertinently, the current inflation is also within the 5% target set for quarter ending March 2017 and medium-term target of 4% for the five-year period ending 2021.

In support of the decision, Patel has cited global uncertainties, financial turbulence, likely increase in Federal (Fed in short) rate by USA, expectation of increase in the price of food etc. The first two factors have existed all through; had these been so compelling, the RBI ought not to have cut the rate even during January 2015 till April 2016.

As regards food price, in monetary policy statement accompanying the October 4, 2016 review, the RBI 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.”

Since then, the only development is demonetisation (November 8). Contrary to much hype about its likely impact on agriculture, sowing during current rabi, 2016-17 has not been affected (Dr Ramesh Chand, member Niti Aayog expects growth to be 5% during current year) Therefore, food price scenario won’t change.

With regard to the Fed rate, true, the FRB (Federal Reserve Board) of USA has increased it by 0.25% (second time in a decade). This, together with strengthening dollar against rupee, may increase the risk of capital outflow. But, to infer on this basis alone that funds will move out of India is far-fetched.

The real driver of foreign funds inflow is confidence in Indian economy, ease of doing business and pace of reforms. In all these areas, the rating agencies have given full marks to the government. This will ensure that even after Fed rate hike, foreign investors will stay invested in India.

Clearly, none of the factors mentioned by the RBI were so compelling as to disallow a rate reduction. It is simply the ‘fear’ of inflation that haunts men at the helm in the apex bank. They do not even bother to introspect that the connection between interest rate and inflation especially from demand side is very weak.

They merely proceed on the premise that any reduction in interest rate would exacerbate inflation by boosting aggregate demand. This is flawed. 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.

Food inflation
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. Clearly, interest rate is not a deterrent and it has no role in inflation management. The MPC should come out of this flawed inflation-interest nexus.

Instead, the committee should seriously think through as to how monetary policy can be galvanised to spur growth. Keeping interest rate low is very crucial to give a boost to small and medium enterprises (SMEs) including startups. Hitherto, a majority of the SMEs were cash driven and have been battered by demonetisation. In this backdrop, lower rate on loans will be a great help.

Lower rate is also needed to improve viability of infrastructure projects like roads, rails, power, port etc, and enable them provide utilities and services at competitive tariffs. It will also help reduce interest subsidy that banks give to keep cost of credit to farmers low. It will enh-ance the competitiveness of our exports.

At present, banks are flush with funds (already, in the follow up to scrapping of notes, they have got deposits worth Rs 13,00,000 crore) and a lot of these would remain in low cost savings and current accounts . This will enable them to reduce cost of funds. But the RBI should not use this as an alibi for avoiding cut in policy rate. Hope, in the next round, it makes the right move.

(The writer is a New Delhi-based policy analyst)

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