With a fourth successive policy rate cut of 25 basis points on October 4, 2019, the cumulative reduction of rate cuts is a 135 basis points. By RBI’s own admission the “Monetary transmission has remained staggered and incomplete” So, in essence, the RBI’s monetary policy during the current fiscal has become an excessively routine and theoretical exercise with undue focus on an accommodative stance.
The RBI Governor’s earlier observation that there is space for a further rate cut had raised expectations in the market and so the rate cut when it happened was obviously in line with market expectations.
The arguments for a policy rate cut set out in the MPC resolution have been based on a benign retail inflation outlook which provides a policy space to reduce the interest rate thereby bolstering the domestic investment demand and then reviving growth. The resolution claims that the projections done before are in line with the actual developments in Q1 which is below the mandated target of average 4 per cent. The actual inflation outcome was 3.2 per cent in Q2 (April- August) of the current fiscal. The projection by MPC is 3.4 per cent in Q2 of 2019-20 and 3.5 -3.7 per cent in H2 of 2019-20 and 3.6 per cent for Q1 of 2020-21.
The outlook on growth has been slanted to the down side. The actual outcome was lower than the RBI’s projection. As a result the RBI has taken a pessimistic view on growth outlook with a 5.3 per cent growth in Q2 of 2019-20 and in the range of 6.6 -7.2 per cent for H2 pf 2019-20 and growth rate of 7.2 per cent in Q1 of 2020-21.
In the above context it is pertinent to mention that in the context of maintaining price stability what is important is anchoring inflation expectations. In September 2019 the Inflation Expectation Survey conducted by RBI showed inflation expectation by households has risen by 40 basis points over a 3 month horizon and 20 basis points over a one year horizon. Besides, there were downside risks to the inflation outlook emanating from volatility of crude oil prices, vegetable prices, and depreciating bias in currencies of several emerging markets. The RBI has taken all these downside risks and has maintained that the retail inflation will remain sub- par 4 per cent.
Since retail inflation will continue below 4 per cent and growth is slowing down, the MPC experts have taken recourse (and of course they have been taking recourse since February 2019) to a textbook solution to revive growth. The textbook solution is since inflation is low and GDP growth is falling it is important to revive GDP growth by increasing aggregate demand (both consumption and investment demand). The best possible way to lower the overnight policy rate and then align it to the overnight market rate (in this case it is the weighted average call money rate which is also the operating target of the monetary policy rate). Once the overnight market rate gets reduced the interest channel of monetary policy forces the longer term interest rate. and ultimately the bank lending rate. Lower bank lending rate will boost consumption of durable goods and investment in capital goods and then eventually help spur GDP growth. Technically, this is also known as the transmission mechanism of monetary policy
The above narration looks sound and logical but there is a big gap between the cup and the lip. The monetary transmission has been very weak. It is important to mention that as against a cumulative policy repo rate cut by 110 basis points since February – August 2019 the bank lending rate on fresh commercial bank loans have been reduced by 29 basis points and on the outstanding loans by 7 basis points in the same period. This implies there is a downward rigidity in the transmission on account of structural impediments. It may be further mentioned that the RBI and government in fact have tried to impress upon public sector banks to reduce rates but has not been materialised. Even the infusion of cash by the government to strengthen PSB balance sheets has not been adequately incentivised by the banks to reduce the lending rates.
The MPC resolution recognises the widening of negative output gap (actual output minus potential output) and in this context is hopeful that the fiscal stimulus measures by the Government particularly in terms of corporate tax reduction will “ strengthen private consumption and spur private investment activity” And that the monetary policy interest rate reduction and fiscal stimulus will “ restore growth momentum”.
GDP growth slowdown from the supply side has been the result of weak agricultural and manufacturing growth and from the demand side weak consumption and investment activity. At the end of the day GDP growth is a function of investment which ultimately depends on savings. The negative savings of the government emanating from the persistent revenue deficit( this is a deficit which has resulted from higher consumption expenditure of the government like wages and salaries, interest payments and subsidies)of the government sector has been a drag on the savings to GDP ratio.
The answer to the grave problem is not fiscal stimulus but elimination of the revenue deficit. Similarly, from the supply side it is critical to improve productivity of the economy. Unless strong structural policies are undertaken to enhance labour productivity and total productivity of the economy any attempt to revive growth through the conventional monetary policy route of interest rate reduction will be futile.
-By R K Pattnaik
The writer is a former Central banker and a faculty member at SPJIMR. Views are personal.
Syndicate: The Billion Press
