RBI underlines that a “competitive interest rate” is necessary but not sufficient – and that sufficiency would require “bridging supply constraints, staying the course on fiscal consolidation, both in terms of quantity and quality, and improving governance”

In its mid-quarter monetary policy review announced on Tuesday, the Reserve Bank of India (RBI) appears to have taken a fairly decisive stand against monetary easing for the medium term. A 25 basis points cut in the policy (repo) rate was the widely expected measure from the central bank and the same has been delivered by the Governor. Read in conjunction with paragraph 14 and the concluding guidance provided in the review, this rate cut almost appears to be an afterthought.

Growth- inflation dynamics: limitations of monetary easing In the above context, it is pertinent to note that the most telling comments from the Central Bank are hidden within the six page statement and highlight the urgent need by the government to “revive investment”. In a strongly worded statement, the RBI underlines that a “competitive interest rate” is necessary but not sufficient – and that sufficiency would require “bridging supply constraints, staying the course on fiscal consolidation, both in terms of quantity and quality, and improving governance.” Clearly, the RBI is highlighting the limitations of the credit channel of monetary policy transmission in the backdrop of persistent food inflation, anchored inflationary expectations and the morass created by the inertia in strategically addressing massive supply side bottlenecks. Thus, the message from the Governor is that monetary easing by itself would not transmit to growth if inflation persists. This is heartening as it comes despite the deafening clamour for a significant rate cut from marketmen and even some senior bankers, in the run up to the policy review. There is very little evidence on the ground of a trend reversal in food inflation since the last policy review on January 29th.

Challenges

A perusal of the policy statement highlights three significant contextual challenges that need urgent resolution.

Inflation management: supply side constraints Widely referenced research in the context of the US economy and indeed elsewhere, indicates that monetary policy tightening leads to a decline in output growth in 4 to 6 months and a drop in price levels around a year after tightening. Memory is short-lived and it is easy to forget that India witnessed one of the longest periods of monetary policy tightening in recent history (2010-11), with very little impact on headline inflation. The persistent and now widening “wedge” between wholesale (WPI) and retail (CPI) price indices driven by stickiness in food inflation is a cause of rising concern for the RBI. Addressing this clearly falls in the domain of the government and requires time-bound action to urgently augment supplies of vegetables and proteins (pulses, egg, milk and meat).

Monetary and liquidity pressures: inefficient Government cash management
Liquidity management by the RBI (ensuring adequate flow of credit to productive sectors) is a sub-set of its monetary management objectives (ensuring non-inflationary growth). The effectiveness of these activities depends not only on external factors such as current account deficit (CAD) and capital flows but also on domestic macroeconomic factors related to the level of fiscal deficit (ratio of gross fiscal deficit to GDP) and the financing of the same. A concern with respect to the latter is the periodic and persistent fluctuations in government cash balances with the RBI. The policy statement observes with some discomfort that these balances have been higher than the “indicative comfort zone”. Such fluctuations exert avoidable pressures on short-term liquidity and can best be avoided through co-ordinated monitoring and forecasting.

Financing of CAD: stable capital flows remains a challenge

The policy review recognises the adverse implications arising out of the record high CAD level and dependence on volatile sources of capital for plugging the deficit in the short run. This assumes greater importance in the backdrop of headwinds to the global economy and the rapidity with which foreign portfolio investors switch between risk-on and risk-off modes to investing in a globally inter-connected financial market.

Such persistently high levels of CAD and (more importantly) such potentially volatile sources of financing the CAD significantly reduce the headroom available to the RBI to ensure effective transmission of monetary policy measures to the real sector.

Again, it is imperative that the government aggressively target long term stable capital flows (FDI) in the medium term to stabilise the situation.

To conclude, RBI seems to be clearly signalling that it has reached the limits with respect to any substantive monetary easing unless there is concerted, visible government action to address the aforesaid challenges. Until that happens, it would be a fallacy to assume a lower interest rate regime. Clearly, RBI has dug its heels in.

(The authors are professors at S.P. Jain Institute Of Management and Research)

persistently high levels of CAD and potentially volatile sources of financing the CAD significantly reduce the headroom available to the RBI to ensure effective transmission of monetary policy measures to the  real sector

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