RBI Policy: A Happy Monetary-Fiscal nexus

In an interesting move, unexpected by many, the RBI decided to change the stance of monetary policy from calibrated tightening to neutral and to reduce the policy repo rate by 25 basis points to 6.25 percent with a vote of four to two.

RBI Policy: A Happy Monetary-Fiscal nexus
The government superseded the board and appointed Kotak as its chairman in October 2018.

On Feb 7, the Reserve Bank of India announced a monetary policy—the first under the governorship of Shaktikanta Das—which was very different from those in earlier years. In an interesting move, unexpected by many, the RBI decided to change the stance of monetary policy from calibrated tightening to neutral and to reduce the policy repo rate by 25 basis points to 6.25 percent with a vote of four to two. The governor favored the cut and as expected, carried the team along.  The shift in stance provides flexibility in addressing challenges to sustained growth. Thus, there is a clear shift from an unnecessary emphasis exclusively on inflation to a balanced objective of price stability and growth. This balanced approach is very essential in a country with young demographics where job seekers have to contend with self-employment.

The governor’s statement, very elaborate and transparent, clearly articulated the reasons that favored the reduction – low food inflation; softness in commodity prices, especially crude; global financial stability and bond yields easing; index of industrial production slowing; inflationary expectations moderating; and export growth flattening. Credit growth of around 12.8 percent was rather muted. While services recorded a credit growth rate of 23.2 percent, credit flow to industry was at a mere 4.4%.

In the global setting, the U.S. Fed Reserve’s policy rate rose to 2.5 percent through December 2018, but may not see similar hikes in 2019. The situation at the Bank of England is similar, where the policy rate has been at 0.75 percent since August 2018. The trend in banks’ non-performing assets has also been stabilising. The yield curve on government securities had not been linear given the uncertainty and direction of monetary policy, and awkwardness in the relationship between monetary and fiscal authorities. 

It is heartening to note, after a long time, that the RBI has not blamed the central government for fiscal profligacy.

Working In Tandem

The large borrowing program has already been factored in, and the rate cut happened despite it. And why not? Fiscal pundits know that despite a very marginal slippage in the gross fiscal deficit, a debt-to-GDP ratio of around 46 percent is robust, when compared historically or with a galaxy of countries.

On the eve of the monetary policy, three of the 11 public sector banks emerged out of prompt corrective action regime, and can now resume their normal banking and lending operations. A few more can be expected to emerge out of PCA during the year. This can address the issue of liquidity. That said, additional measures, especially in terms of a calendar for open markets operation, have already been announced.

The initiatives on regulatory and supervisory aspects like the establishment of an umbrella-like organisation for urban cooperative banks—a long pending demand—would provide credibility to the sector while promoting financial stability. The two measures on financial inclusion of enhancing limits on collateral-free agriculture loans and setting up of a study group to recommend measures to improve credit delivery in the rural sector are in seen supportive of the union budget’s initiatives directed at farm sector. The harmonious relationship and complementarity between monetary and fiscal policies are conducive for creating an environment that would promote higher growth in the economy.

Toward Better Data

In the last few weeks, since the new governor assumed charge, there has been a sudden change in the monetary environment in the country. Although it is too early to empathetically observe, there is a change for the better in the analytical presentations of documents accompanying the monetary policy as well as publications like the annual report on ‘Trend and Progress of Banking in India’, and the ‘Financial Stability Report’ released in December 2018. The depth and transparency in the contents of publications have already improved as also the interaction with the media. The governor has certainly brought in fresh air in the making of monetary policy. Now, there is a need to review the inputs that help in deciding the interest rate policy.

Should it be data-driven or information-driven? The data gets dated in the process of collection, and when crunched through models, the output delivered is based on assumptions. Fresh information, from regional centers and different locations in the country, even anecdotal, can help in understanding ground realities at the grass-root level. Similarly, the RBI’s inflation model also needs to be strengthened, because forecasts have persistently been higher than actuals.

Positively-biased inflation forecasts, constant over the long-term, distort policy prescriptions and tend to lose credibility.

The working of the monetary policy also indicates a certain level of confidence in the fiscal authority. The budget of February 2019 supports the generation of demand, especially in the rural areas, and could be expansionary over time, impacting industrial growth and demand for financial services.

The reduction in interest rates could also strengthen the expansionary phase and help India achieve a growth GDP rate of nearly 10 percent by encouraging the housing sector (which has linkages with nearly 275 industries) through lower monthly installments, and MSMEs by extending credit to new startups and mudra loans. In this way, monetary policy is supporting the efforts of the fiscal authority which has the primary objective of growth and generating employment. One aspect of the necessity of generating employment is that labor is productively engaged.

In the ensuing year, given that the projected inflation rate is expected to be less than 4 percent, and real interest rate in the range of 3 percent-plus, there is scope for further reduction in nominal interest rates. In view of the beginning of the slack season, a further cut of nearly 50 basis points cannot be ruled out in the next few monetary policy meetings, to push the economy into, and sustain, higher growth.

(The author is Charan Singh, Chief Executive, EGROW Foundation. Views expressed are author’s own)

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