Who really moved my interest rate?

The monetary policy of the Reserve Bank of India has become one of the most watched media events these days in the light of persistent demands to lower interest rates. This undue attention on the monetary policy points to how much change the country has witnessed in policy framework and socio-economic environment in recent years.

Historically, India has not been an inflationary economy. The high episodes of inflation (21% in 1974-75, 20.2 in 1980-81 and 15.2% in 1991-92) were on account of disruptions in oil prices which were unpredictable and sudden. However, the period of inflation, which surfaced in 2008-09 and still remains a threat, was as a result of the contribution from food components in the consumer price basket. In other words, the potential threat to inflation stems from the persistence of food inflation.

Generally, it is believed that food inflation is on account of supply shocks. But there is also a strong demand-side problem. When the economy has moved from the lower level of per capita income (rate of economic  growth minus rate of population growth), say 1.5 to 2% in the 1950s to 6.5% currently, the income in the hands of the public has gone up.

Of course, there is disparity but the higher per capita income has led to a significant shift in consumption and dietary patterns which have changed to favour protein (pulses), animal protein and fruits, vegetables etc. This is also otherwise known as protein inflation. Initiatives like the Minimum Support Prices (MSP), the Mahatma Gandhi Rural Employment Guarantee Act (MGNREGA), rise in rural credit, increased female participation in the labour force are some of the contributing factors on the demand side.

These are positive initiatives but what also shows up is the lack of foresight of the policy makers to recognise that  when the income levels go up, consumption patterns will change and the economy should be prepared to absorb the  resultant supply  shocks. Urgent policy intervention to augment protein and vegetable production, and an emphasis on agriculture production should have been the supply side policy focus of the government. India has failed on this front.

When supply doesn’t match demand, what we get is inflation, and monetary management of inflation has to be done predo-minantly through the lever of interest rate. This apart, liberalisation and globalisation have brought their share of challenges alongside in terms of the volatility of capital flows to India. We don’t know when there could be a flood of capital and when the surge becomes a trickle, stops or reverses, placing undue pressure on the currency.

The RBI has to manage this volatility, which it does through its monetary instruments like the open market operations and cash reserve ration (CRR) at the long end and repo and reverse repo rates in the short term.  These instruments are used to either suck out or add liquidity depending on the market conditions, resulting in an impact on interest rates. Thus, what has come into focus is the price of quantity of money, that is, interest rate. Accordingly, the RBI moved to directly making interest rate as the target variable to control inflation and to anchor inflation expectations.

This is in a marked contrast to the earlier RBI policy framework, which focused on credit management and then on quantity of money management, taking into account money demand in the economy and matching the supply of money (the so-called ‘money stock’ or ‘broad money’ or ‘M3’). This approach was followed later by a multiple indicator approach, recognising not only money supply but also other indicators such as fiscal deficit, current account deficit, capi-tal flows etc. These interventions also impa-cted interest rates but in an indirect manner.

Indirect control

The indirect control of interest rates worked well for some time but slowly became redundant when it was recognised that the avowed objective of monetary policy is price stability, linking monetary management with liquidity management. Under this approach, what we have now is a direct focus on short term interest rate signalling through the overnight policy repo rate.

When inflation persisted, every increase in the policy repo rate made the cost of borrowing from the credit market costlier (the bank lending rate increased). With this, the industry captains became unhappy. But, on the other side, when the RBI reduced the policy repo rate, the corresponding reduction in bank lending rate did not follow and credit did not pickup. The RBI thus is caught between the devil and the deep sea.

In the ultimate analysis, markets and the government clamour for a lower interest rate to drive credit uptake and augment investment. However, the threat of inflation stands in the way. This challenge was faced by RBI governors in the recent past but had a particularly snowballing effect during the tenures of D Subbarao and Raghuram Rajan, partly because governments were getting impatient and industry became more demanding.

In his book, “Who Moved My Interest Rate,” Subbarao says, “…the high interest rate regime would be the main area of difference between the government and the RBI.” And as Rajan succinctly noted in a press release on June 20, 2016: “We can never abandon inflation to focus on growth.”

This then is the central bank’s philosophy, which all stakeholders, particularly the government and the markets, must recognise and respect. So the answer to “Who really moved my interest rate?” should be quite simple: It is not the RBI but a host of conditions, not all of which the RBI can or does control.

(Pattnaik is Professor at SP Jain Institute of Management and Research, Mumbai, and Rattanani is Editor, SPJIMR)
(The Billion Press)