The clamour and chorus for RBI to cut rates grows louder as the credit policy day approaches closer. My view is that despite slumping growth, rates should not be cut due to the overwhelming need for monetary stability.
To understand the current scenario, we need to start with some basic macroeconomics. Leaving aside government?s contribution to GDP, growth is mostly driven by investment?in the macroeconomic sense of machines and infrastructure and houses built in that period. Investment, in turn, is largely driven both by business conditions and interest rates. Business conditions, what I shall call BC, are driven by a mix of factors?underlying growth and market potential, costs, and the ease of doing business (land acquisition, getting government clearances, etc). Under normal circumstances (when BC is normal), raising interest rates lowers investment and growth while lowering them stimulates growth. But when BC is deeply depressed, cutting interest rates will not revive private investment, despite very low rates, as was the case after Lehman Brothers collapsed in late 2008.
Right now, India is experiencing DBC?depressed business conditions, maybe deeply DBC. Under DBC, lowering rates is not likely to stimulate growth. In this situation, those against rate cuts are undermining their strong case by putting forth flimsy justifications. Sajjid Chinoy starts by insightfully pointing out that ?the current slowdown is more prolonged and acute than even the quarters after the Lehman crisis? (FE, June 12). He then makes two statements. First, the slowdown started in mid-2010 before RBI started hiking rates in early 2011. Second, he states that, ?The rate hikes were efficacious in bringing down inflation. The seasonal adjusted, quarter-on-quarter momentum of core inflation had risen to almost 11% in February 2011 (which presumably prompted the more aggressive tightening that followed) but fell to less than 5% in August of that year?clear evidence that the rate hikes were working. So monetary policy does matter in controlling inflation?. His bottom line?rate hikes will not harm growth, which was falling anyway, and at the same time will lower inflation and thereby benefit the economy.
While I am also against rate cuts now, the second statement above does not follow from the first. One cannot have it both ways: attribute the drop in growth to DBC, and attribute the simultaneous drop in inflation to RBI?s rate hikes, rather than to weak growth itself. Further, a detached observer could go one step further and suggest that there is no harm in cutting rates?inflation (non-food manufacturing WPI, or core inflation, RBI?s preferred policy measure that Chinoy also focuses upon) is falling anyway?so a policy with ?half a chance of half success? of arresting some of the drop in growth under DBC should be initiated.
Nevertheless, there are justifications against easing, at a time when growth will remain weak due to DBC. These justifications require us to go beyond the narrow domain of industrial production and core WPI to some neglected aspects of the broader economy. First, the relevant measure of inflation for policy is CPI, both for expected inflation and as a smooth measure of actual inflation?three-year average. Intra-year movements in inflation are mostly noise. Further, core inflation is a dubious concept, whether of WPI or CPI, and has hindered, not helped, policy across the world. These two strong assertions about suitable inflation measures need to be supported, in separate articles.
Both the measures of actual and expected inflation are plotted in the chart. As can be seen, despite the slight drop in expected inflation, from 11.9% to 11.0% last quarter, the three-year average remains very high. For the last 10 quarters, both these measures have been above 10%. This is perhaps the single-most important fact that RBI should take into account in framing its policy.
Monetary instability is now rife in India, with growing purchases of gold by the public, mostly as an inflation hedge. Higher gold imports will weaken the rupee exchange rate, lead to more inflation, and may induce forex instability. A clear indicator of monetary instability is chronic coin shortages. A few months ago a newspaper reported that, ?fed up by the constant shortage and increased black marketing of coins, wholesale traders in Mumbai have minted their own coins and are using them as currency?.
Coins are melted for profit when the metallic value of the coin significantly exceeds the face value. It must be pointed out that the disparity between the metallic and face value of a coin grows even when inflation falls, since the price level is still rising. RBI should pay less attention now to the global financial meltdown and more to the local currency meltdown.
Cutting rates now will make real rates even more negative. Under DBC, this may seem a worthwhile way to try to boost weak growth, which, in turn, has been lowering core WPI inflation. But the negative real rates induce financial imbalances in the rest of the economy. A low ?cost of carry? induces commodity arbitrages that indirectly push up the price of food and other crucial items. It may turn out to be the worst of both worlds?lower rates will not boost growth under DBC, but push up CPI inflation by raising food prices. Crucial inflation will go up, while ?core? inflation may stay low.
Under what circumstances should RBI consider easing? There are grounds for easing if credit demand drops drastically so that market interest rates begin to decline below corresponding policy rates, as occurred after September 2008. But right now that is not the case. The repo window is in deficit mode, and CD rates are well above 11%. RBI should also avoid cutting the cash reserve ratio (CRR)?although meant only to ease liquidity, a CRR cut will also raise aggregate demand, lower the cost of funding for deposits and thereby also contributes to financial imbalances. And before I forget, there is so much inflation in the pipeline when administered prices (petrol, diesel, rail fares) get raised, that there is a compelling case for a 25 basis point rate hike to signal RBI?s willingness to fight inflation.
The author is a professor of economics at IIM, Bangalore