How RBI Fixes Interest Rates? Why call for Cuts?

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TOPIC: General Studies 3

• Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

In news: RBI recently kept its key lending rate, the repo rate unchanged at 6% dashing hopes for lower borrowing costs of households.

The 6 member Monetary Policy Committee headed by RBI Governor kept one eye firmly by rising inflation that is inching closer towards RBI’s 4% threshold level. In August, MPC had recommended 25 basis point cut to 6%. More cut was asked to revive investments for spending and aid a turnaround in broader economies growth that has slumped to 13 quarter low to 5.7% in April-June.

Reason for RBI’s decision

RBI is answerable for only one thing- Inflation. If it goes beyond 4%, it will have to explain to the country and parliament.

Food inflation is okay and crude prices seem to have stabilized. However, they also revise the growth forecast from 7.3% to 6.7%. So here is a situation where MPC is telling that between growth and inflation, they will only worry about inflation.

Manufacturing growth rate is 20 quarters below. RBI has not reduced growth figures much. This means in coming quarters, growth can happen more. Inflation can increase upto 4.2%-4.6%. This is worrying factor and thus not reduced the repo rate. If the manufacturing sector and industrial sector has to be revived, then there is need of reduced repo rate. However, ease of doing business is fine, but the cost of business must be also rationalized.

Competitors are growing and exports are also increasing- Brazil, Indonesia, Malaysia, South korea are going in export trajectory. India is failing behind due to high cost of business and ease of doing business.

Lower policy rates

The policy rates are down to historic low of 6%. This is not high in Indian economic conditions. The real interest is down to 1.5 percentage points. This is not desirable as required is always 2%. The low interest rates applies to both savers as well as investors. In the present situation, where low interest rate is desired, it cannot be so due to difficult social and economic conditions facing vast majority of people. Post demonetization, the funds are getting channelized through mutual funds into stock markets. Apart from it, there are no avenues for savings. It’s a major disincentive as savings rates are down.

Why RBI worried about inflation?

Due to fiscal policy slippages that are anticipated. The economy is running on one engine of government investment. The scope is not large for growth on this path. Also, the state governments get into competitive spree as elections approach to implement pay commission recommendation for their staff. The state finances are not as good as they looked before. So the states would be landing up borrowing. The competitive populism in terms of loan waiver.

These things have contributed in closing doors for policy rate reduction.

In august they forecasted inflation from 3.5 to 4.5%. Now it is 4.2% to 4.6%. Where does this one hundred basis point increase come from?

1. In the first half of 2017-18, the assumption of oil prices was 50$ per barrel. Now it is 55$. So the global oil prices are fed into domestic inflation.
2. Monsoon has been 5% below normal. Earlier it was above normal or normal monsoon.
3. Fiscal situation- current forecast is 3.2% of GDP. However the number of downside risk to fiscal slippages have increased.

These are three things impinging upon inflation.

Why only inflation targeting by RBI?

The central government has told the RBI to be inflation targeting institution. Monetary policy framework agreement should have put both inflation and investment or credit growth as two key factors and calibrate it so that when RBI is worried about growth, it focuses on growth and when worried about inflation, more focus on that.

Inflation targeting is not being discussed because of the trap the economy and policy makers are into. The trap is whether the headline cpi inflation is going to increase when half of it is not under their control, as it is dependent on supply side factors. To get out of it, the credibility has to be damaged.

Two key takeways from monetary policy are:

1. Inflation is going up
2. Growth is coming down

If there is a high inflation and low growth scenario ahead, it is difficult for policy makers to navigate.

The tradeoff between growth and inflation is not an artificial one. Both are complementary. The good economic growth is not positive unless macroeconomic policies are under control. Inflation price stability is an essential condition of growth. Thus, monetary and fiscal policies should be targeting inflation because that is growth complementary.

Way forward– Growth should come from

1. MCLR is not working well. It is not effective to transmit the reduction by RBI in repo rate. It should be re-worked.
2. Focus on stalled projects. The infrastructure is not getting that much pace. It should help competitors increase their place in market place.
3. Reviving manufacturing sector– focus on MSMEs and ease of doing business. It helps to increase growth number in industrial sector and overall growth trajectory.

Economy is facing slowdown. Price stability is good for growth and vice-versa. There is difference between MCLR faced by borrowers and inflation.

The global economy activity has strengthened but the Indian economic story is not the same. It is because there is no driver for investment. Hence, the demand is not expected to be boosted. Monetary tightening switched demand and in addition, demonetization accentuated it as all money went to banks. From banks, nobody is borrowing. So money is not coming out. Hence, private investments should be encouraged and credit lending should increase to give the much needed nudge to economic growth.

Connecting the dots:

• RBI is just an inflation targeting institution. Do you agree with the statement? Comment.