Rajeev Malik: Monetary policy isn't a popularity contest

If the RBI cuts interest rates now, it will prolong the much-needed macro adjustment

A lot has changed since the last monetary policy announcement from the Reserve Bank of India in April, in which it unexpectedly cut the repo rate by a bigger-than-expected 50 basis points, to eight per cent. However, it tactically balanced that aggressive signal – the actual transmission was much weaker – with an equally unexpected guidance of limited room for further easing. Since then, however, a sense of urgency in government actions remains missing (forget words, as they are cheap); global uncertainties have increased; and international commodity prices have declined, but India’s headline inflation has risen — and is poised to rise further. The rupee collapsed as the overall balance of payments will likely be in deficit for the third straight quarter, and GDP growth plunged to a pathetic 5.3 per cent in the January-March quarter. The RBI’s approach of not being wedded to a particular rupee level and sensibly avoiding its senseless defence by running down foreign exchange reserves has saved us so far from a bigger disaster. I know it is difficult for people, including some economists, to think of massive exchange rate depreciation as being positive, but in the kind of the macro cross-currents India finds itself, currency weakness is part of the solution, not part of the problem.

The poor GDP data (which will probably be revised up, but with a long lag) have raised the decibel level of cries for rate cuts by the RBI. Amazingly, India is the only country in Asia where consumer price inflation is almost double the pace of real GDP growth. And there are calls for interest rate cuts, despite government inaction being a much more important factor than interest rates for the precipitous drop in economic growth.

As with faulty currency analysis – as a result of which almost all analysts missed the warning signals about the rupee debacle and the slump in growth – the clamour for rate cuts to boost growth mistakenly assumes a normal economic cycle response function. It is time to wake up: India is experiencing an abnormal economic cycle in which inflation, thanks to the government, has become more entrenched. Consequently, it is less sensitive to slower growth.

India’s economic cycle continues to have a lopsided fiscal-monetary mix that has resulted in consumption being boosted at the expense of investment, and inflation becoming more entrenched because of the government’s populist policies. Essentially, the government in recent years boosted aggregate demand via consumption without facilitating higher aggregate supply.

The fact is conveniently overlooked that inflation has been higher than real GDP growth for several quarters. Boosting aggregate demand via interest rate cuts rather than enhancing aggregate supply will only worsen the inflationary pressures in the near term. Even if an investment upturn adds to aggregate supply, it does so with a lag. In any case, boosting aggregate demand from, say, higher investment should be matched by shrinking the fiscal overhang and moderating consumption growth. In the absence of such finely balanced recalibration – itself a challenge – India will suffer a more protracted macro adjustment.

Trend GDP growth has been decelerating because of government policy inaction and the fallout of the corruption scandals. Trend growth is probably around 6.5 per cent, well below the RBI’s guidance of 7.6 per cent. Higher trend growth needs government action to create a more enabling environment for investment recovery, and undertake supply-side measures and reforms that will result in a lasting decline in inflation. That will then facilitate a significant and sustained decline in interest rates. Until then, India will have to live with a combination of below-trend growth and still-high inflation.

A critical issue is whether the current level of the repo rate is too high. Now, just because GDP growth has decelerated and investment is on hold doesn’t necessarily mean that interest rates are too high, especially if the government’s policy paralysis has worsened the downturn. Also, the appropriate policy rate should balance the returns to depositors with the cost of borrowers. Given the uncertain global capital inflows, it is critical to encourage domestic resource mobilisation.

However, even the current repo rate is well below CPI-new inflation. The RBI is questionably married to WPI-core, but consumer price inflation matters more for depositors. Perversely, the RBI focuses on WPI-core (April: 4.9 per cent year-on-year) while depositors deal with consumer price inflation (April: 10.4 per cent with core at a mindboggling 10.3 per cent). With still-high inflation, further interest rate cuts will increase the tightness in domestic liquidity as depositors will not find interest rates attractive especially at a time when foreign capital inflows are weak and remain uncertain. Indeed, it is striking that the deceleration in GDP growth in recent quarters has been accompanied by rising loan-deposit ratio.

Perhaps the most convincing evidence of firmly entrenched inflation and inflation expectations is the talk of rate cuts despite double-digit consumer price inflation. The decline in the prices of global commodities, especially crude oil, eases multiple pressure points, such as the twin deficits and inflation, without the government undertaking any meaningful corrective action. However, the government’s myopic approach is not ensuring greater macro stability, especially since it does not provide a long-term fix for supply-side drivers of inflation and for a backlog of overdue price adjustments.

Interest rate cuts are not the near-term panacea for India’s growth problem. It is surprisingly overlooked that rupee depreciation has already significantly eased monetary conditions. Further, rate cuts may not necessarily boost growth: Brazil has slashed the policy rate by 400 basis points since mid-2011, but its GDP growth continues to slide, hitting 0.8 per cent year-on-year in the March quarter.

Finance ministry mandarins don’t seem to realise that it is high inflation that has become inimical to growth. We need to ensure greater confidence towards sustained low inflation rather than a quick fix. It is helpful that central banks have a longer time horizon than governments and self-serving financial markets. Also, the RBI should seriously benchmark India’s inflation relative to that of its trading partners. That is important as India’s higher relative inflation threatens to return us to the almost forgotten days of annual rupee depreciation. Everyone thinks of currency movements impacting inflation but few realise that inflation also affects the currency, as has been the case with the rupee.

Politicians, bureaucrats, pop macroeconomists, columnists lobbying for businesses and some market participants talking their own book conveniently – and myopically – argue for a quick fix of cutting interest rates. India definitely needs a policy response but it has to come from the government, not the RBI right away, especially after the bigger-than-expected rate cut in April.

Frankly, the RBI should not be in the business of doctoring financial markets’ mood to make up for the government’s inaction and incompetence by ignoring the over 10 per cent consumer inflation just before an uncertain monsoon. If it attempts to do that by responding under political pressure, or as if in a popularity contest, or as a prisoner of market expectations, it’ll only be contributing to the very macro instability due to entrenched inflation it is trying to address.

Business Standard - Wednesday, June 13, 2012