Does monetary policy really matter? Financial Express 28th August 2014

Does the interest rate really matter today, or for that matter, even monetary policy? A lot of focus is on RBI and its monetary policy which holds the reins on the repo rate, considered to be the signaling rate for the financial system. There has been intense debate on whether or not interest rate action can bring about growth or lower inflation. If you are a monetarist, you would argue that monetary policy can attack inflation. If you support Keynes, then the growth potential of interest rates would dominate your set of arguments. As is the case with any argument in economics, there are two sides to the story, and one is never sure which one is right as there are compelling arguments on both sides. But the Indian situation is quite unique and does not go with both these schools. Let us look at growth's relationship with interest rates. Industry always argues that lower interest rates are a necessary condition for growth to take off. Theoretically, it is right because when rates are lowered, the investor is better placed to juxtapose the internal rate of return with a lower interest rate for taking a decision. The question then to be asked is as to which level of interest rate will really get industry to invest more money today? Investment decisions are based not just on current interest rates but expectations of the same in the future. If they are expected to come down further, then decisions would be postponed as locking into an interest today may not be ideal. Therefore, while one can argue on whether RBI needs to lower rates by 50 bps or 100 bps, the precise amount that will spur investment is not clear and will depend on other conditions. Now, let's look at the capacity utilisation rate in industry today. It was around 75% in March, which means that industry has surplus capacity. If output needs to be scaled up, it can be done within the existing capacity. What is important is the demand for the product. This has been the Achilles heel for us, where demand has lagged and has created a disincentive to invest. In fact, the inventories-to-sales ratio was 17% (going by RBI data for March 2014), which indicates that companies could offload their finished goods first if demand increased and still have spare capacity to leverage for meeting final demand. Hence, by lowering interest rates, RBI may not actually have industry going in for large doses of investment unless we see commensurate traction in consumer demand. Curiously, when interest rates were increased in FY11 and FY12the repo rate went up from 5% to 8.5% (on a point-to-point basis)capital formation in current prices continued to increase by 17.1% and 18.9%, respectively, indicating that interest rates were not a limiting factor. During these two years, GDP growth was 8.9% and 6.7%, respectively. Subsequently, while rates have come down and then increased to 7.5% in FY13 and 8% in FY14 (especially after May 2014), growth in capital formation slowed down to 7.3% and 4.6%. This means that if growth is buoyant, interest rates do not matter, and when growth is low, investment will not take place as demand is low. Interest rates act further as a deterrent. Therefore, the takeaway is that merely lowering interest rates and assuming that the transmission is smooth through bank lending rates, borrowing will not necessarily pick up. Demand has been hampered due to inflation. Food inflation, particularly, has impacted the purchasing power of households which have had to cut back on both consumption of manufactured products, especially durable goods, and financial savings. Consumer goods growth has been low, a negative 12.6% in FY14 over growth rates of 2.6% in FY12 and 2% in FY13. Such demand cannot be revived by lowering interest rates, as an inflationary environment does create consternation in the minds of households who have to plan for the future based on such expectations. Therefore, the issue comes back to inflation control as a factor influencing consumer demand. Can monetary policy influence inflation? Again, the answer appears to be a shrug, coupled with absence of optimism, when we look at the CPI figures. If one looks at the weights of the components, the following picture emerges. Food has weight of 49.7%, fuel 9.49%, clothing 4.7%, and 9.8% for housing. Few components here would be based on credit for most households. Then, there is 7.6% for transport and communications, 3.4% for education and 5.7% for medical expenses, where a very small part is addressed through credit. But to the extent that credit is used for purposes like education or medical purposes, interest rates would not be a limiting factor as these are necessities. Therefore, by linking monetary policy to CPI inflation, we are starting on a shaky note as interest rates have little bearing on most components. It could just mean that we are chasing a crooked, never-ending shadow. When monetary policy targeted the WPI number, it looked more feasible as it was a producer's index which was largely met through leverage and hence impacted investment decisions. However, today by targeting an index which may not be impacted by the policy tool, the objective of inflation control may not be realised. In fact, monetary policy may be viewed more as a reaction policy to the phenomenon of inflation. A better way to read the policy will be to say that the policy will be aggressive to retain positive real interest rates and adjust nominal rates to inflation. This means that the use of the traditional trade-off between growth and inflation, something which has been spoken of by textbooks and assiduously pursued by monetary authorities, may not really hold. Taking this a step forward, it goes beyond the rational expectations theory which says that monetary policy cannot affect growth, but also contests monetarism by saying that the best it can do is to adapt to inflation, when it cannot control it. The crux really is that when we have a situation of supply-driven inflation and low-demand led growth, working on the production side and going in for pump-priming a la Keynes could work. At any rate, monetary policy may not really matter.