Rajan said that RBI has been “wise to disregard advice in the past to cut more deeply”, while observing that high inflation has burdened middle-class savers and poor with “hidden inflation tax” for decades when industrialists and governments were paying “negative real interest rates”.
Stating that he gets “a lot of heart-rending letters from pensioners complaining about the cut in deposit rates”, Rajan said he can understand why the pensioners are upset when they see their interest income diminishing.
He further said inflation is now contained fairly close to the upper bound of RBI’s target zone, which suggests “we have not been overly hawkish, and were wise to disregard advice in the past to cut more deeply”.
Giving a lecture here at Tata Institute of Fundamental Research, Rajan said, “While higher inflation might help a rich, highly indebted, industrialist because his debt comes down relative to sales revenues, it hurts the poor daily wage worker, whose wage is not indexed to inflation.
In his first public appearance after announcing his decision against a second term, Rajan said he would never abandon inflation control to focus on growth, but admitted there is indeed a short run trade-off between inflation and growth.
“In layman’s terms, if the central bank cuts the interest rate by 100 basis points today, and banks pass it on, then demand will pick up and we could get stronger growth for a while, especially if economic players are surprised.
“The stock market may shoot up for a few days. But you can fool all of the people only some of the time. If the economy is producing at potential, we would quickly see shortages and a sharp rise in inflation.”
Rajan said, “We had gotten used to decades of moderate to high inflation, with industrialists and governments paying negative real interest rates and the burden of the hidden inflation tax falling on the middle class saver and the poor.
“What is happening today is truly revolutionary – we are abandoning the ways of the past that benefited the few at the expense of the many.”
Calling from adjustments from all constituencies, the Governor said, “if industrialists want significantly lower rates, they have to support efforts to improve loan recovery so that banks and bond markets feel comfortable with low credit spreads.”
“The central and state governments have to continue on the path of fiscal consolidation so that they borrow less and thus spend less on interest payments. Households will have to adjust to lower nominal rates, but must recognise that higher real rates make their savings more productive.”
Expressing confidence in a “low inflation future”, Rajan said the government will then be able to borrow at low rates, and will be able to extend the maturity of its debt.
“The poor will not suffer disproportionately due to bouts of sharp inflation, and the middle class will not see its savings eroded.”
Rajan, who has often been criticised by the industry for not lowering the interest rate enough to spur demand and boost economy, questioned the rationale behind their demand and tore into their logic with his analysis of inflation and rate data.
“When someone berates us because heavily indebted industrialists borrow at 14 per cent interest with wholesale price inflation at 0.5 per cent, they make two important errors in saying the real interest rate is 13.5 per cent.
“First, 7.5 per cent is the credit spread, and would not be significantly lower if we cut the policy rate (at 6.5 per cent today) by another 100 basis points.
“Second, the inflation that matters to the industrialist is not the 0.5 per cent at which their output prices are inflating, but the 4 per cent at which their profits are inflating (because costs are falling at 5 per cent annually).
“The real risk free interest rate they experience is 2.5 per cent, a little higher than elsewhere in the world, but not the most significant factor standing in the way of investment.
“Far more useful in lowering borrowing rates is to improve lending institutions and borrower behaviour to bring down the credit risk premium, than to try and push the RBI to lower rates unduly.
“The policy rate in effect plays a balancing act. As important as real borrowing rates for the manufacturer are real deposit rates for the saver.”
Sticking to his outspoken attitude, Rajan said savers in the last decade have experienced negative real rates over extended periods as consumer price inflation has exceeded deposit interest rates.
“This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.
“This meant that India needed to borrow from abroad to fund investment, which led to a growing unsustainable current account deficit.
“The bottom line is that in controlling inflation, monetary policy makers effectively end up balancing the interests of both investors and savers over the business cycle.
“At one of my talks, an industrialist clamoured for a 4 per cent rate on his borrowing.
When I asked him if he would deposit at that rate in a safe bank, leave alone invest in one of his risky friends, he said ‘No!’ Nevertheless, he insisted on our cutting rates significantly. Unfortunately, policy makers do not have the luxury of inconsistency,” he said.
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