Reserve Bank’s policy rate reduction is arbitrary

The Monetary Policy Committee (MPC) resolution on August 07, 2019 with a 4:2 votes decided to reduce policy repo rate by 35 basis points, an oddity in the sense that past changes have been in rounded-off packets of 25 basis points, usually. It may be recalled that RBI Governor Shaktikanta Das, who is also the chairperson of the MPC, had forewarned that policy repo rate cuts could be higher than 25 basis points. A member of the MPC, Prof. Ravindra Dholakia, in the previous MPC resolution, had in fact preferred a 40 basis point reduction.

In a textbook sense, the MPC has many reasons for which it has offered a rate cut. First, observed inflation and inflation outlook measured in terms of Consumer Price Index Combined (which means Rural and Urban combined, abbreviated as CPI-C) continues to remain benign and is projected to be within the target of an average of 4 per cent over the coming one year period. The actual data pertaining to headline CPI inflation (which is otherwise called retail inflation) placed it at 3.2 per cent in June 2019 and the core inflation (headline inflation minus food and fuel inflation) was at a moderated level of 4.1 per cent in June 2019. RBI estimates put inflation for Q2 of 2019-20 at 3.1 per cent, for H2 at 3.5-3.7 per cent and for Q1 of 2020-21 at 3.6 per cent – all of it in what might be called the “green” zone as it is below the targeted inflation rate of 4 per cent. Second, there has been transmission of past rate cuts during February-June by 29 basis points on fresh loans, implying weighted average lending rates are lower by 29 basis points, which is far less than what is desired. The MPC hopes this will pick up and therefore has gone for a bigger rate cut.

Thirdly, economic output (growth) is lower than the potential output, giving us a negative output gap. Fourthly, investment and private consumption demand, which are true drivers of real economic growth measured in terms of GDP at constant prices, has remained subdued. Thus, going by the legislative mandate of monetary policy objective (which is “price stability keeping in mind growth”), MPC in its conventional wisdom intended to address growth by enhancing aggregate demand through an expansionary monetary policy with a focus on interest rate reduction. As far as the outlook on growth for 2019-20 is concerned, the MPC revised it downwards to 6.9 per cent from 7 per cent in the June policy. The downward revision has been more pronounced in H1 of 2019-20 as it was in the range of 5.8-6.6 per cent as against 6.4-6.7 per cent. However, for H2 of 2019-20, the growth estimates have been 7.3-7.5 per cent and further Q1 of 2020-21, it is projected at 7.4 per cent. Thus, the growth outlook has been shifted upwards from 6.9 per cent to 7.4 per cent in the near future.

Given the benign inflation outlook coupled with moderated inflation expectations, the rationale behind the above projected growth trajectory is that a reduction in interest rates will help boost investment and thereby aggregate demand and eventually deliver real economic growth. But will this textbook solution suffice to enhance economic growth? Interest rate reduction has some adverse implications also on the savings of the economy. The lending rate reduction by the banks could not be sustainable without a deposit rate reduction by the banks having a chain reaction of overall interest rate reduction thus affecting financial savings.

The MPC in its resolution is completely silent on the fiscal policy, which is another important arm of the economic policy. Evidence suggests fiscal arithmetic of the union budget lacks integrity as there is a large deviation when the budget estimates are translated to revised estimates after one year and actuals after two years.

Since the time lag is high, the discussions regarding lack of fiscal marksmanship are often not in memory and lack traction in the public domain. However, the fiscal slippages in receipts, expenditures and deficits has its consequences in the private sector investment. In this context, it is important to mention that in the 2019-20 union budget, there has been a large slippage in the revenue receipts but the fiscal deficit was maintained more or less at the budgeted level by increase in disinvestment proceeds. However, this increase was effected by selling equity shares among the public sector units and not in the market.

Even though revenue deficit (which otherwise means dissaving of the government) is not a part of Fiscal Responsibility and Budget Management (FRBM) Act, 2018, however, predominance and persistence of revenue deficit above 2 per cent has adverse implications not only for economic growth but also for higher fiscal deficit and thus higher borrowings by the government. Besides higher revenue deficit perforce reduces investment expenditure by the government. For e.g. the capital expenditure of the union government is around 1 per cent of the GDP. Given the complementarity of public and private investment, lower public investment has an overall dampening effect on the economy and tends to shy away private investment, particularly in areas of education and health.

Economic growth moves in a circular fashion like a wheel. Investment and consumption are two important drivers. However, predominantly consumption-led growth particularly by the government sector is not sustainable. Investment-led growth, both by government and private sector, is desirable. However, the rule based fiscal policy limiting the deficit and debt relative to GDP has turned the focus to accommodative monetary policy. The policy repo rate is currently at 5.40 per cent.

The inflation rate is expected to be sub-par 4 per cent. Thus, on a rough estimate, the real interest rate is around 1.4 per cent. The MPC has so far not explicitly given what is the appropriate and sustainable real interest rate, except some members arguing that real interest rate is high. Without a benchmark real interest rate, this type of rate reduction is arbitrary and not sustainable.

(The writer is a former Central banker and a faculty member at SPJIMR)