Wait and Watch Monetary Policy

Dr Ashwani Mahajan
On April 5th, 2016, Reserve Bank of India (RBI) announced its first Monetary Policy Review for the financial year 2016-17. Though, continuing the trend of reducing interest rates, Repo Rate (interest rate at which banks borrow from RBI) has been reduced from 6.75 percent to 6.50 percent, Cash Reserve Ratio (CRR) has been kept intact at 4.0 percent. Although using some other measures, like reduction in marginal standing facility (MSF) rate by 75 basis points to 7 per cent, RBI has tried to improve liquidity in the economy, market which had expected a much bigger reduction in interest rates showed its displeasure by sharp decline in the share prices. It is notable that market experts believed that Repo rate would be brought down by at least half percent. It may be noted that after 2010, RBI started increasing interest rates due to high rate of inflation. ‘Repo rate’, which was only 5 percent in 2010 increased to 8.5 percent by 2012. Later on RBI started reducing the policy rate and now it stands at 6.5 percent. Never the less RBI has been moving cautiously and actually followed ‘wait and watch’ principle. It seems that RBI is still not confident about stability of prices and high growth trajectory in the near future.
Unfounded Apprehensions of RBI and Rating Agencies
It seems that RBI is apprehending a fresh spurt of inflation due to implementation of 7th Pay Commission and One Rank One Pension (OROP) principle, apart from monsoon uncertainties. Rating agencies like ‘Moody’s’ are also airing the similar concerns apart from fearing depreciation of rupee. However, their apprehensions seem to be unfounded for more than one reason. Firstly, after a long time, weather forecasters are seemingly in consensus, that this year monsoon would be normal and India is likely to witness bumper crop. Secondly, rupee has been improving consistently in the ‘last more than one month, primarily due to consistently improving condition in balance of payment deficit on current account (CAD) and also persistent surplus in balance of payment on capital account. There does not seem to be any reason for commodity prices to move upward in near future.
As per the Chief Economic Advisor, Arvind Subramanium, India’s economy has been passing through deep deflationary situation. Though growth is picking up, wholesale prices of commodities including metals and crude have been coming down. An important indicator of inflation, called GDP deflator is clearly indicating at deflationary situation, due to which, GDP growth in monetary terms is slower than real GDP growth. This situation is though rare, causes not only shortfall in revenue, even incentive to increase production also gets adversely affected.
Situation is no different is other parts of the globe. To deal with the problem of slowdown, USA, European nations, Japan and many other countries have reduced their interest rates to near zero level. USA has been following a most unconventional monetary policy in the name and style of ‘quantitative easing’. Today, when, retail inflation is less than 5 per cent and wholesale inflation is in negative zone for nearly 15 months; there is almost certainty about normal monsoon with GDP growth expected to be nearly 8 percent, with hardly any danger to the stability of rupee, RBI could have easily gone for improving the liquidity position in the country, satisfying the thirst of the market and bring improvement in the market.
Imperative for Courageous Monetary Policy
RBI governor has been time and again pleading for transmission of lower interest rates to the borrowers. No doubt, this act of the banks would improve the demand for credit and increase much needed liquidity in the system. However, by suggesting this, RBI cannot absolve itself from its duty to reduce interest rates. To tackle the problem of deflation in the economy, there is an urgent need to reduce interest rates significantly. There is no doubt that once policy interest rates are reduced, demand for credit to build roads, bridges, airports and other infrastructure would go up; and consumer demand will also get a boost. It is notable that in the past, whenever interest rates were lower, growth was boosted. For the first time, when the economy could surpass the hurdle of low growth rates (what used to be called ‘Hindu Rate of Growth’), it was basically due to low interest rate regime. During NDA-I, under Prime Minister Vajpayee, lower interest rates gave boost to development. Rate of growth of industrial development, which was hardly 4.1 percent in 1998-99, reached 8.4 percent by 2004-05. Country witnessed a fast expansion of road network and other infrastructure under Public Private Partnership (PPP) projects. Huge housing demand gave a big boost to housing. Perhaps a major factor which helped the development was low interest rates. For instance at a rate of interest of 8 percent on a housing loan, equated monthly instalment (EMI) on 20 years loan of 10 lakh was hardly Rs. 8360, whereas a housing loan of the same maturity at 10 percent rate of interest, one needs to shed Rs. 9650 as EMI. Expectedly, lower rate of interest led to expansion of demand for cars and other automobiles, consumer durables, housing etc.; apart from encouraging entrepreneurs to expand their businesses.
During UPA-2, high rate of inflation and resulting high interest rates, led to downfall in economic activity. Rate of capital formation, which had reached 37 percent at one point of time, nosedived to 31 percent, due to high interest rates. Therefore there is an urgent need to reduce interest rates, especially when economic situation is ripe for the same. Dispelling unfounded fears, RBI should reduce interest rates, especially ‘Repo Rate’ to atleast 6 percent and usher in an era of lower interest rates to boost growth.
(The author is Associate Professor, PGDAV College, University of Delhi)