Will RBI’s accommodative policy stance be effective?

Mumbai : Governor Raghuram Rajan has reduced the policy repo rate by 50 basis points to 6.75 per as against the market expectation of 25 basis points reduction. As he has mentioned, this is a front loaded accommodative monetary policy approach “while recognising that continuing policy implementation, structural reforms and corporate actions leading to higher productivity will be the primary impetus for sustainable growth”.

In the above context, we pose two questions: First, what are the advantages of the rate reduction? Second, what are the downside risks to rate reduction?

The answer to the first question critically hinges on the present and near term growth and inflation outlook, besides the timing and magnitude of rate reduction.  The CPI Inflation rate has been moving southwards. However, some upward movements are expected from September onwards, with a reversal of base effects. Inflation is expected to reach about 5.8 per cent in January 2016 – a shade lower than the earlier RBI estimates of 6 per cent. The growth outlook is somewhat gloomy and weak because of sustained decline in exports, rainfall deficiency, slowdown in industrial production and investment activity. Therefore, the RBI has revised its downward projected growth rate for 2015-2016 by 0.2 %, to 7.4 per cent. Thus, the inflation rate is moving along RBI’s trajectory, but the growth rate is lower.

The need for monetary easing thus arises, not only to revive confidence, but also to mitigate the uncertainty in the market, particularly the private sector. Further, both money market and government bond rates have been lower, responding to a comfortable liquidity position and earlier policy rate reduction. The ECB and FED have not enhanced their key policy rates, so that the adverse impact in terms out flow of funds from India is not imminent. One may, therefore, hasten to conclude that the timing of the 50 basis point reduction is appropriate.

While we welcome the rate reductions by RBI on the basis of the above, we are flagging a few downside risks. First, the pay commission fiscal stimulus has a strong potential to enhance aggregate demand and thus pose a threat to inflation. Second, it is savings that facilitate economic growth. A rate reduction will lower deposit rates and there is a potential danger of  overall savings rate coming down in the banking sector. Third, front loading of policy rate reduction will not have the immediate benefit of lending rate

reductions, as evidence suggests that there lags in the transmission process. Fourth, accommodative monetary policy based on the assurance of the government to meet its fiscal target is dangerous in terms of inflation expectation. We have enough evidence to prove that this does not work. Fifth, the process of ‘joint action of the government and RBI to remove the impediments to banks passing on the bulk of the cumulative 125 basis points cut on the policy rate’ is not clear. Is it suggestive of an arm-twisting approach?

On balance, while the RBI’s accommodative stance in its fourth bi-monthly policy raises no eyebrows, we wonder, will the accommodative monetary policy by RBI be effective in its intended objective?

* The authors are professors of Economics at the S.P. Jain Institute of Management and Research, Mumbai. Views are personal.

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