Ashwani Mahajan
Recently Monetary Policy Committee (MPC) has one again decided, not to reduce policy rate of interest. This decision of the MPC has drawn a lot of criticism, especially from the Finance Ministry. There is nothing new about tussle between Central Government and RBI about interest rates. It is well known that Central Government generally wants RBI to reduce policy interest rates to boost growth. This is so because, if interest rates decline, demand for houses, cars and other consumer goods will increase, with cheapening of loans. With lowering of interest rates, investment increases not only in industry and businesses, even new infrastructure also gets encouraged. Dream of purchasing a house or of a car, could easily be accomplished with cheaper loans. Moreover, largest borrower in our country is Government, low interest rates reduce cost of borrowings by Government, and lower interest burden may help in larger outgo for welfare expenditure by Government.
But the Reserve Bank does not agree with the Government about interest rates. It says that the monetary policy is not only about growth but also price stability. The Reserve Bank says that since the inflation is yet not stabilised, therefore, the reduction in interest rates is a risky proposition, and it may lead to inflation by increasing the demand.
What does Government say?
Chief Economic Advisor (CEA) Arvind Subramanian says that since CPI inflation rate had dipped to merely 3.73 percent in May 2017, economy could have been easily given a boost by reducing interest rates, or in other words one can say that MPC has wasted an easy opportunity to boost growth.
Generally, RBIs argument has been that real rate of interest should be reasonably positive and therefore first condition to reduce rate of interest is reduction in inflation rate. It is notable that in this regard, a rule is followed in majority number of countries, that is, ‘Taylor Rule’. This rule was propounded by an economist of Stanford University, Prof. John B. Taylor. According to this rule, in inflation targeted monetary policy, policy rate of interest is determined by rate of inflation, after some adjustments. In India policy rate of interest in ‘Repo Rate’, that is, the rate at which commercial banks borrow from RBI. ‘Taylor rule’ stipulates that policy rate is obtained by adding expected real rate of interest to rate of inflation and further adding half of difference between real rate of inflation and desired rate of inflation and half of difference between logarithm of real GDP and potential GDP (as determined by a linear trend).
It is notable that target rate of inflation was earlier fixed at 6 percent before February 2016 which was reduced to 5 percent and ultimately to 4 percent is April 2017. Therefore since CPI inflation had come down to 3.73 percent, therefore repo-rate was obviously expected to be reduced accordingly, as per ‘Taylor Rule’.
RBI may have a hitch that this reduction in inflation rate may not sustain in the long run. RBI’s recent monetary policy statement says that in the second half of 2017-18, inflation may increase. However, point to be noted is that, actual inflation rate has generally been lower than the inflation rate projected by RBI. For instance RBI projected an inflation rate at 5.0 percent in the third quarter of 2016-17, which actually turned out to be only 3.7 percent. Consistently erratic projected inflation rate given by RBI, underlines the need to improve the projection process and also change the adamant attitude, not to reduce repo rate.
Consumer or Wholesale Inflation?
Another point of core importance is that in inflation targeted monetary policy, which measure of inflation should be adopted, consumer or whole sale inflation. Till 2014, target inflation used to be based on wholesale price index (WPI)? In its report a committee under the stewardship of the then Deputy Governor of RBI, Urjit Patel (Present Governor of RBI) recommended in favour of using consumer price index (CPI) based inflation rate in inflation targeting, and since then consumer (retail) inflation in being used for inflation targeting. It doesn’t make any difference normally, whether we use CPI or WPI. However, in special context of India, there has been big difference between rate of inflation under CPI and WPI in India. It is notable that rate of inflation has been only one percent between 2013-14 and 2016-17 as per WPI, whereas the same has been 5.8 percent based on CPI. Therefore, whereas based on Urjit Patel committee, target inflation rate was shifted in favour of CPI, repo rate was made impossible to be reduced even with negative or zero WPI inflation. Reason for this huge difference between CPI and WPI in India is that CPI inflation has been high due to high food inflation and high weights assigned to food items in CPI; whereas, in WPI, weight assigned to food items has been only 22 percent. Therefore, choice of CPI as target inflation, made it impossible to reduce repo rate for long time.
Imperative to Reduce Interest Rates
Given widespread recession in the world today, there are very little prospects for export driven growth. An increase in investment (whether in business or in infrastructure), is also very important. In such a situation, it’s imperative to reduce interest rates. However, consumer inflation targeted monetary policy on the one hand and Reserve Bank’s consistent misunderstanding of inflationary trend on the other, have been coming in way of reduction in repo rate. RBIs adamant attitude towards rate cut has been coming in the way of growth, which is not good for the country’s health.
(The author is Associate Professor, PGDAV College, University of Delhi)
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