Let me clearly state that this piece is not to espouse for a rate cut (or even rate increase!). In the interest of full disclosure, I do believe that the time is not yet ripe for a rate easing cycle and December 2 will not see any rate easing from RBI. However, with inflation consistently undershooting, and Q2 GDP numbers at 5.3% (do you know, it may have been a purely fortuitous one, driven by a surge in government expenditure for natural calamities like the Jammu and Kashmir floods), monetary easing will be sooner than later. The moot points that we are going to debate in this piece are some common monetary policy and associated fallacies that we are currently entrapped in.
First, the recent debate on estimating equilibrium real interest rate as unleashed in academic domain may be literally irrelevant. This is because evidence suggests that the postulated association between real interest rate and savings may not have a theoretical as well as an empirical truism. In theory, high real interest rates have two opposing effects on private savings. Empirically, authors have found and with particular reference to India that such an envisaged relation may not hold true always. If this is the case, then the entire focus of estimating an equilibrium real interest rate is misplaced.
Second, the oft-repeated argument that the real policy rate has to be positive also means rise in inflation above the expected rate may automatically lead to rise in the policy rate. This contravenes Taylor’s principle that the response in the nominal interest rate will be in response to both growth and inflation differential above the potential level and expected inflation. In an econometric exercise, such a specification may lead to multicollinearity as a rising trend of inflation will simultaneously harden inflation expectations (through the
Third, it is fine that we must ensure a positive real interest rate for our savers, particularly pensioners. But by that logic, we must also ensure that lenders are not discriminated against through a higher rate. What we can do in this context is we must ensure pensioners are exclusively privy to interest rates above the market through design of new products.
Fourth, the argument that a Fed rate hike in 2015 is imminent and that may act as a constraining factor for domestic monetary policy decisions. Let me assure you that with continued deleveraging of households it is unlikely that the US GDP growth will approach on a sustained basis the trend level in coming quarters because debt-based financed consumption has natural limitations after a point. This will mean that Fed rate hike may be delayed beyond 2015. As of June 30, 2014, total consumer indebtedness was at $11.63 trillion, marginally below its 2008 Q3 peak of $12.68 trillion. The matter is no different in Europe.
Besides the fact that household finances are in disarray, the sociological trends in US household are also alarming. For the first time since 1976, a majority of adult Americans, 50.2%, are single, according to the Bureau of Labor Statistics. Economically, this is worrisome because this will adversely impact the new “household formation”, decelerating future sale in housing, cars (no wonder General Motors was bailed out), consumer durables items required for married couples. Already, the outstanding student loan balances reported on credit reports increased to $1.12 trillion (+$7 billion) as of June 30, 2014, representing a $124 billion increase from one year ago and this will only result in delayed marriages compounding the effect further. With such a thin buffer of assets, low-income families in the US—the subprime cohorts (including the retiring baby boomers)—could be vulnerable to market shocks, thus constraining the Fed’s capacity to hike rates.
Added to this, the ECB’s announcement of a QE in 2015 may open the floodgates of more capital inflows into India, given the attractive interest rate differential. Alternatively, RBI in such a case may be faced with a Hobson’s choice, of controlling liquidity abundance or squeezing the rate differential through rate cut.
Fifth, the recent decline in oil prices may be short-lived and these are not dictated by structural factors and hence we must be careful. By that logic, then, all financial variables that go down must go up. Remember, our oil price basket was derived at the beginning of current fiscal on a $106 per barrel assumption. Today, the prices have declined close to $70. Hence, even if oil prices go up, it will be still significantly less than the assumption. Also, empirical evidence suggests that no central bank have been able to ignore a significant downturn in oil prices!
The sum total of all this: We are now in a situation of entrenched disinflationary impetus and a lower interest rate regime may only be a matter of time (we can though conjecture regarding the time). The RBI discomfort regarding the rates moving down is still palpable if we take the announcement of OMO sale as an indication (it can even go for shortening the LAF corridor). But, let us also give kudos to RBI for at least making us believe and debate today that nothing is impossible, and for that matter even a 6% CPI target!
(Co-authored with Saket Hishikar, economist)
By Soumya Kanti Ghosh
The author is chief economic advisor, State Bank of India.
Views are personal