Expectations, not policy, key to recovery: Financial express October 25 2019

While the mandate has been to address inflation, the Committee, in its deliberations, has extended the brief to growth, but never to impact on savings, which influences growth through the consumption route.

The last decade or so has seen a plethora of attempts made on the monetary side to resuscitate economic growth across the globe, and India has not been free from this. Using interest rates to prop up the economy is a semi-Keynesian approach, which uses monetary measures to stimulate the economy. Keynes spoke of fiscal stimulus through higher government spending since, in extreme cases, this was the only option when the economy entered a liquidity trap where there was limited demand for funds. We are not yet in such a trap; hence, lower interest rates still sound plausible as a means to revive growth.

Monetarism associated with Milton Friedman had averred that money supply affects only inflation, and markets always clear. Hence, monetary policy can affect inflation, but not growth. This means that we cannot use credit measures to revive an economy in a market-driven system, and, hence, monetary policy was aligned with inflation targeting. This was further buttressed by the Rational Expectations school, which is associated with Thomas Sargent and Robert Lucas. The theory states that just macroeconomists’ assumption that people are rational holds for macroeconomics where all people know the model of the economy that policymakers use.

Hence, if the government increased the growth in money supply to reduce unemployment, it would work only if the government increased money growth more than people expected, but the long-term effect would be higher inflation, and not lower unemployment. With all information, which can be taken to mean all policy measures and structures, in place, governments cannot drive the economy, and the only way to do so is to keep changing stance to make policy effective.

Post-financial-crisis, the Fed and ECB have used interest rate and unconventional measures of buying asset-backed securities (ABSs) from banks to provide liquidity in the system. This has been the main driver of policy; even today, president Trump is severe on the Fed for not lowering rates further, and the ECB has gone in for a fresh round of quantitative easing. This was invoked as a panacea for all ailments, but has had limited success.

Let us look at the US, where the Fed rate came down from 4.75% in September 2007 to a range of 0-0.25% in December 2008, and increased only in December 2015 to 0.25-0.5%. Growth has been between 0-2.8% post a negative growth rate in 2009. The eye has always been on containing inflation at less than 2%. But, this has not really helped to push up the economy, and with unemployment rate really low, one does not know if rate cuts will increase spending. The Euro region has been struggling for almost a decade, and growth impulses seem to be muted; the ECB has kept the deposit rate at nil since 2012 from a high of 3.25% in October 2008, pre-financial-crisis. Growth has crossed 2% only twice since 2011.

These developments prove ex post that monetary policy has not worked, and that the solution lies elsewhere. Maybe fiscal policy where government spends more to create demand, or, if the issue is structural, there can be no quick fix and change will only occur gradually.

Let us look internally too. The repo rate is now down by 135 bps, and the impact has been quite timid. While the pro-rate-cut economists have badgered banks for not transmitting the cuts, the fact remains that no one borrows money because it is cheap. There needs to be a reason to borrow money—any investment that is not commensurate with pickup in demand for the relevant goods will carry a fixed capital cost with low return. Similarly, individuals do not borrow if they do not have purchasing power; this is where income matters. This, in turn, means that more people need to be employed. The government’s view, going by EPFO data, has been that job creation has been rapid, in which case, if they are not spending, there is an issue.

Now, interest rates at the policy level have been decreased substantially, and probably will continue to be lowered as the RBI projection of growth has been scaled down, which means that logically, to be consistent, the MPC has to lower rates if inflation is less than 4%. This is the challenge when the relentless lowering of rates losing its bite in case of a real recession, a concern raised in the west, holds for India too.

In the Eurozone, for example, the rate is already negative for banks which keep deposits with the ECB. In case the economy slips further, the rates cannot go down further, and that will make monetary policy impotent. The same holds in India as the repo rate is now close to 5%, and it looks likely to go below this mark in the remaining months of the calendar year.

One normally tends to look at interest rates from the borrowers’ perspective, never the lenders’. As rates drop, the returns earned on savings fall, and, if used for consumption, brings the overall spending level down, creating a ratchet effect. Therefore, it is necessary for monetary policy to also weigh this effect. Curiously, none of the MPC statements or discussions mention this factor that has contributed to muted demand and affected growth. While the mandate has been to address inflation, the Committee, in its deliberations, has extended the brief to growth, but never to impact on savings, which influences growth through the consumption route.

World growth accelerated at a time when globalisation was at its zenith, and cross-border trade and investment flourished. Post the financial crisis and Euro region imbroglio, things have changed. No longer does the invisible hand work towards countries automatically supporting other nations symbiotically. Protectionism has increased, and trade treaties have been placed on the side-table. Now, growth has to be internal, and the US is talking of ‘US first’, just as we are propagating the ‘Make in India’ dogma. In such a situation, it will be hard to break the barrier to growth. Fiscal policy, too, has its limit as while we can ask the government to spend more, it has to be within limits set by prudence.

Therefore, it does appear that there are limits set to economic theories, and we need to follow the path of Rational Expectations, where the market should be left alone. As long as companies and other growth agents keep expecting rates to come down further, or government to take more fiscal measures, there will be deferment of decisions. This is why the upward path will be slow, and more driven by statistical biases than real policy impulses.