There is a big difference in the way in which the Groupthink directs opinion and the MPC considers the same, and the way in which banks and markets react.
Interpretation and Group think are two driving forces of economic policies in India. Data and statements are open to everyone, but the way they are looked at is interesting. For a long time, we maintained, with a touch of hubris, that India was the best performing economy even if growth slowed down and fewer jobs were created. At the same time, there was an aggressive Groupthink on rate-cuts, which became self-fulfilling as all those who influence policy making thought alike.
However, things look quite different, and there is again a buzz.
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Industrial growth in the negative territory and CPI inflation at 4.6% is disturbing. While it would be an exaggeration to call it stagflation, it is definitely a sign of low growth and rising inflation. This situation was never really envisaged, growth was to pick up on the back of the harvest-cum-festival season, while inflation was to fall due to a good kharif harvest. However, both have not quite played out.
IIP growth in September should ideally have increased for durables goods, in particular, as the e-commerce business was brisk, with both the leaders, Amazon and Flipkart, claiming high growth in sales and penetration to Tier 2 and Tier 3 cities. This should have been ideally backed by higher growth in IIP in September.
This also has not happened, and is a substitution for physical sales.
While harvest was supposed to be good, the delayed withdrawal of the monsoon and stormy conditions in November has damaged horticulture products and pulses in some parts. This translates into a fall in supplies, leading to a sharp increase in prices, which has upset calculations.
In such a situation, it is almost axiomatic for one to ask for another rate cut, which is now a habit. This is also happening in the US and Euro region, and, hence, is not surprising. In fact, there has been strong Presidential talk in the US, which is absent fortunately in India where it has been left to the MPC to decide on rate action. The argument being made is that, while inflation has increased beyond 4% and will remain in this terrain for the next few months (can cross 5% if vegetable prices go up further), it should not be considered permanent. Hence, focus should be on growth.
There are two things to be discussed. What exactly is the mandate of the MPC? Is it to react to current inflation number or expected inflation or core inflation or food inflation? Interestingly, one of the earlier Governors of RBI, in a press conference, had clearly said that the legislative mandate of the MPC was to target inflation, and that too headline inflation. There could, hence, be no deviation from this goal. Yet, the MPC has now taken a view that growth is more compelling. With inflation being in the 3% range, it has chosen to lower the rate by 135 bps since February.
The second, is that there is an anomaly in reasoning when one looks at the way in which Groupthink moves. The rationalisation is that since food inflation has gone up—core inflation has come down—there is strong reason to lower the repo rate. However, around six months ago when the headline number moved up and was driven by core inflation (house rent, education and health), food inflation during this period was extremely low, the same argument was never made, and the MPC had focused on the headline inflation number. Hence, it would be interesting to see if the MPC breaks away from its conventional approach of viewing inflation and moves to the core inflation aspect when deciding on the rate cut.
A rate cut per se has not quite helped spur investment. The 135-bps reduction is, thus, more of a policy move. It really hasn’t worked through the system. This is not surprising as there is less appetite for funds and the credit-risk factor is high. Ideally, change in policy rate takes time to go through banks, but markets should react with alacrity. In this context, let us take a look at how the 10-years GSec yields have moved over time. See graph for average 10-years GSec yields for the period December 2018 to October 2019. The repo rate has come down by 135 bps, the yield is down by only 77 bps, which means that the market transmission has not been that even.
This raises the question on why does even the market not react to the repo rate changes? Markets tend to take in a lot of information from different pockets when pricing bonds. Hence, the repo rate and the future direction of the same is just one factor. For these securities, there is considerable uncertainty on the government’s fiscal deficit and the incremental borrowing programme. The corporate tax rate cut is to lower the revenue by Rs 1.45 lakh crore. GST collections are not on track and there is not much momentum on the disinvestment front. Therefore, the yields reflect this sentiment.
There is a big difference in the way in which the Groupthink directs opinion and the MPC considers the same, and the way in which banks and markets react. Banks have been asked to use benchmarks for pricing their SME and retail loans. The transmission still has not been smooth. Also, the credit risk assessment continues to be apprehensive given the economic environment. Therefore, the way in which players react is different from the thought process of the MPC.
At an ideological level, it is pertinent to ask two questions. The first, whether we are right in targeting the CPI which sends conflicting signals once we get into the core and food inflation debate. The discourse on justification of rate action becomes weak as consistency fades when this picture of inflation composition changes.
The second, whether we should have fewer credit policies with the prerogative to intervene at any time when there is volatility. This is important because one of the reasons to shift to six policies was to remove the noise in expectations on policy. One used to be terrified of getting up in the morning to be told before 9 am that the RBI had slashed or raised the repo rate or the CRR due to adverse market conditions. But, today there is more certainity for sure as Groupthink has led to relentless interest rate cuts, linking the same with the objectives of inflation targeting has gotten blurred.
We clearly need to go back to basics. This is an issue also in the US, where the Fed has lowered rates with inflation at a low, unemployment at its lowest and a steady GDP growth. Friedman and Keynes would both have been bewildered.
The writer is Chief economist, CARE Ratings. (Views are personal)