Column: Does monetary policy really matter?

Aug 28 2014, 02:52 IST
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SummaryBy linking monetary policy to CPI inflation, we are starting on a shaky note as interest rates have little bearing on most components. It could just mean that we are chasing a crooked, never-ending shadow

Does the interest rate really matter today, or for that matter, even monetary policy? A lot of focus is on RBI and its monetary policy which holds the reins on the repo rate, considered to be the signaling rate for the financial system. There has been intense debate on whether or not interest rate action can bring about growth or lower inflation. If you are a monetarist, you would argue that monetary policy can attack inflation. If you support Keynes, then the growth potential of interest rates would dominate your set of arguments. As is the case with any argument in economics, there are two sides to the story, and one is never sure which one is right as there are compelling arguments on both sides. But the Indian situation is quite unique and does not go with both these schools.

Let us look at growth’s relationship with interest rates. Industry always argues that lower interest rates are a necessary condition for growth to take off. Theoretically, it is right because when rates are lowered, the investor is better placed to juxtapose the internal rate of return with a lower interest rate for taking a decision. The question then to be asked is as to which level of interest rate will really get industry to invest more money today?

Investment decisions are based not just on current interest rates but expectations of the same in the future. If they are expected to come down further, then decisions would be postponed as locking into an interest today may not be ideal. Therefore, while one can argue on whether RBI needs to lower rates by 50 bps or 100 bps, the precise amount that will spur investment is not clear and will depend on other conditions.

Now, let’s look at the capacity utilisation rate in industry today. It was around 75% in March, which means that industry has surplus capacity. If output needs to be scaled up, it can be done within the existing capacity. What is important is the demand for the product. This has been the Achilles heel for us, where demand has lagged and has created a disincentive to invest. In fact, the inventories-to-sales ratio was 17% (going by RBI data for March 2014), which indicates that companies could offload their finished goods first if demand increased and still have spare capacity to leverage for meeting final demand. Hence, by

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