RBI increased interest rates twice in July. It raised the repo rate by a quarter of a percentage point to 5.75% and the reverse repo rate by half a point to 4.5%. This has set off a raging debate. A senior officer at RBI went public with the comment that RBI should have taken a more aggressive stance and raised the interest rate further, in order to fight inflation. He was put in his place, highlighting the fact that RBI functions more as an arm of the ministry of finance with decisions taken on the basis of consensus rather than by voting, as is common with the Federal Reserve and the Bank of England.
The recession of the 1990?s and the early part of this decade saw central banks adopting unconventional monetary policies to prevent a second Great Depression. Extensive liquidity was provided in domestic currency and intervention carried out in fixed income markets. It is only in recent months that the fears of recession have receded. Governments have started considering an exit from fiscal stimulus. Serious thought has been given simultaneously to an exit from the low interest rate regime. It has now been realised that low interest rates and unconventional monetary policy cause distortions in the economy and inflate asset prices.
The Bank of International Settlement (BIS), in its 80th annual report, drew attention to the fact that previous episodes of low interest rates suggested that loose monetary policy is often associated with credit booms, the decline in risk spreads and a search for yield. They also cause a serious misallocation of resources. The necessary structural adjustments become painful and take time. Low interest rates have an impact on risk measures. The BIS points out that low policy rates allow ?evergreening?, i.e., the rolling over of non-viable loans. Japan was notorious for zero interest rates in the 1990?s and banks permitted debtors to roll over loans (on which they could afford the near-zero interest payments) without repaying the principal. Low policy rates can paralyse money markets and complicate the exit process. They also have international side effects, especially in emerging economies like India, China, Brazil, etc. Tighter monetary policies in these markets cause significant interest rate differentials, leading to capital flows to countries with higher rates. ?Keeping interest rates very low comes at a cost,? said the BIS, ?a cost that is growing with time.?
Raghuram Rajan, a former chief economist at the IMF and professor at the Booth School of Business, challenges the view that the central banks produce low interest rates and nobody gets hurt. While a low rate of interest may prop up asset prices, especially in the housing sector, an unnaturally low rate may prevent prices from reaching their natural level, holding back the necessary adjustment that the housing market has to make. Rajan avers that ultra-low interest rates are undoubtedly a tax on savers, especially risk-averse ones and tells them to do one of three things. ?It tells them to bear the pain while watching returns on their deposits and money market accounts dwindle to nothing, take more risks to eke out extra returns or to go out and spend.?
The net effect of low interest rates will be the reduction in household income and household demand. The costs are paid by households that forego interest income and benefits are reaped by those that borrow short term. Low interest rates are a direct subsidy to banks. The recent financial crisis was precipitated by Alan Greenspan, who chose to keep rates too low, too long. The most important cost of low rates is the effect on risk-taking and illiquidity-seeking. Responsible savers are made to suffer. Financial savings of Indian households are parked in low yielding assets like bank deposits, while equities form just 10% of savings. This is the reverse of the situation in the US.
Cheap money policy, which emphasises low interest rates, may be all right during a period of depression to encourage investment. But when recovery picks up and the threat of double-digit inflation is looming large, it makes for a strong case to raise the interest rates to a level to ensure that fixed income earners and low- and middle-class savers do not suffer a loss in income. If inflation is at 10% and the deposit rate is 6%, real income is eroded. This is the proverbial inflation tax, which affects the middle and lower income groups. Equity is offended when deposit rates are kept low and such deposits are advanced to millionaires and billionaires for ostensible business purposes at rates that can be significantly higher. Nor is it true that low interest rates helped in building infrastructure. The Japanese experience should show us that keeping interest rates low without doing anything to fix structural problems may have little effect on the economy.
At times when the rate of inflation is changing fast, the real interest rate can be measured on a forward- or a backward-looking basis. The backward-looking basis compares current interest rates with inflation over a recent period. The forward-looking rate compares interest rates with expected inflation over the immediate future period. The forward-looking rate is more relevant to policymaking. It is this perspective that RBI appears to have overlooked in its conservative approach to fixing interest rates, thus putting the credibility of monetary policy at stake.
The author is a former Chief Commissioner of Income Tax and ex-member of the Income Tax Appellate Tribunal