Why not do nothing? Financial Express: 24th November 2008

Inflation, which was a major worry in the last six months, has now eased considerably and there are signs that it will gravitate towards the 6% mark by March end. This is mostly on account of the easing of oil prices that has tempered the price rise. Also, the global decline in metal prices has eased the prices of manufactured products while food prices have been brought down due to the stabilisation of supplies. In this situation, what should be the approach taken by the government?
Today, there is a liquidity problem in the country. During the current financial year the difference between incremental deposits and credit and investment is around Rs 25,000 crore. Credit has been growing, though the allocation could be in favour of agriculture (priority sector) and retail segment. But, the fact that there is a shortage means that the price of credit, which is market-determined, should increase. RBI is trying its best to maintain liquidity through CRR reduction and repurchases in the MSS window, so that government borrowings do not become intrusive. We need to ask ourselves whether RBI should be concerned with the direction of rates when weighed against market conditions.
The Rational Expectations School which was popular in the eighties was an attack on the Keynesian idea that monetary policy could only affect inflation, and not stimulate growth. The logic was that if the monetary authority announced its targets and stuck to them, the market would automatically take decisions based on these guidelines and this would result in an optimum equilibrium. As a corollary, Lucas, Sarjent and Wallace (who are proponents of the School) said that the authority could be effective only if it systematically ‘fooled the public’. This would mean that the policy announced in April would be reversed subsequently and repeatedly, which would affect the growth path as market participants would constantly keep readjusting their decisions based on the policy moves. The School concluded that this was not an efficient way of going about things.
Now let us see what RBI has done. When inflation was increasing during the first part of the last financia l year, it responded with strict monetary controls, raising rates and absorbing liquidity. This sent signals of contraction, and investment and spending plans were curtailed. As it was then the slack season in which investment is typically on a low key, this may not have been disastrous. However, after the global financial crisis resurfaced in August 2008 through the CDS route after the CDO path in 2007, the response was to reverse these policies. This was done by reducing the CRR successively and then touching on the interest rates to make life easier. Today, we are seeing declining inflation but the threat of lower growth has also made its appearance. Under these changed circumstances, RBI faces a quandary. It needs to lower rates to provide succour to the market, but it has little control over the growth of deposits even as demand for credit is increasing.
The efficient way out would be to do nothing and let the markets do the talking. In fact, by lowering rates further today, RBI will be distorting the price mechanism. The banks have quite subtly thrown the onus of lowering interest rates on RBI. On their own, they are offering higher rates on long term deposits because this is the only way to garner medium term funds for deployment, given the shortage of liquidity. This is the reason why the deposit rates are still not coming down even after lending rates have been perforce reduced.
Now industry should not be complaining about higher rates, as interest cost constitutes only around 4-6% of its total cost of production. Yes, liquidity is a concern that can be redressed through CRR intervention. The retail segment lending has slowed down which in a way is good for the banks as it gives them time to introspect.
What should the government do today? The answer is that it should do nothing. The act of constantly tinkering with the interest rates, which moves against the market conditions, should provoke a wider debate.