If the central bank lowers rates when inflation is
still high, it’s an admission its policy has not worked
Traditionally, monetary policy has
been motivated by the twin goals of fuelling growth and containing inflation.
Accordingly, we attribute a Keynesian face or a Friedman-like policy stance to
it. Interestingly, in the last two years or so, there is a degree of skepticism
about whether these theories really make sense when evaluating the efficacy of
the monetary policy.
Further, two other dimensions have
been added. The first is what has been called “pressure by the government” and
the second is “market expectations”.
One is still not sure whether
these two really affect policy formulation; but, given that the finance minister
keeps making statements on the need to lower interest rates and the Reserve Bank
of India (RBI) holds meetings with bankers, one never really knows if such
things matter and become self-fulfilling. Also, in April, RBI lowered the repo
rate, or the rate at which it gives short-term money to banks, with a caveat
that we should not expect more rate cuts soon. This came at a time when the the
finance minister spoke about lower interest rates after presenting the Union budget. There appears to
be some merit in believing that these two factors also matter for RBI.
Given these motivations, what can
we expect? Growth is stagnant. The recent positive industrial growth numbers
should not cloud our vision that things have changed drastically. While a
turnaround from negative to positive growth is good news, we need to wait and
see if this is sustainable from now on. At best, one can say that growth has
bottomed out.
There’s a status quo on inflation,
too. Wholesale inflation rose 7.8% in September with all segments coming under
pressure. Retail inflation is closer to 10%. Inflationary expectations are high,
given that fuel prices have been increased and that the kharif (or winter) crop
will be below optimal.
Now inflation is on the supply
side but RBI has, in its various policies, taken a varied approach to inflation.
At times, it was core inflation that was targeted; on other occasions, it was
food inflation. More recently, it has spoken of retail inflation. Whichever way
we look at it, none of these numbers has come down significantly to warrant a
change in monetary stance.
Also, if RBI lowers rates when
inflation is still high, then it is an admission that the policy has not worked;
and that, as a corollary, its original approach was not right. Therefore, it is
hard for RBI to lower rates.
The so-called pressure put by the
government can be an important factor, considering that the government has done
its bit for reforms and fiscal consolidation, albeit more through announcements
than actions. With banks also looking at the regulator to lower rates and the
cash reserve ratio (CRR) or the portion of deposits that banks need to keep with
RBI, there is indeed pressure on the central bank.
Given all this, RBI could go in
for a CRR cut, though admittedly liquidity is not an issue for the system today.
Still, this will placate the market and leave the banks to decide on interest
rates.
The CRR cuts have not, in the
past, been very effective in lowering rates. While banks have claimed that they
will be in a position to lower rates if CRR is lowered, past experience does not
provide such an indication. Still, cutting CRR and leaving the policy rate
intact should send the right signal to the market, though this may not be
adequate to excite the market which is banking on a rate cut.
I expect a CRR cut of 25 basis
points (0.25%) with no change in the policy rate. One basis point is
one-hundredth of a percentage point. Also, some sort of payment on CRR balances
can be thrown in as an icing on the cake to make banking stocks tastier.
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