The RBI has lived up to people’s expectations by cutting the repo rate. It should avoid being glued to inflation. Instead, the interest rate policy should propel growth

In its bi-monthly monetary policy report, announced on June 6, the Reserve Bank of India (RBI) reduced the repo rate/the policy rate (rate at which the RBI lends money to commercial banks) from the subsisting 6.0 per cent to 5.75 per cent. Together with a reduction of 0.25 per cent, each notified in the previous two reviews (February and April ), it has cut the rate by 0.75 per cent in less than six months.

In another significant move, the RBI has changed its policy stance from hitherto being “neutral” to “accommodative.” Whereas a neutral stance carries with it the possibility of reduction as well as increase (it may even connote no change), an accommodative stance unambiguously points towards a rate cut in future reviews.

That the above decisions represent the unanimous view of all members of the Monetary Policy Committee (MPC) — as informed by RBI Governor, Shaktikanta Das during a Press briefing while announcing the policy — they reinforce the assessment that the interest rate, henceforth, will be on a downward trajectory.

After a long wait, it is encouraging that the RBI is being seen as accommodative of the concerns of the industry and trade even as the country’s Gross Domestic Product (GDP) growth plummeted to an all-time low of 5.8 per cent in the fourth quarter of last year, ending March 31, 2019 (during 2018-19, the growth decelerated to 6.8 per cent — the lowest during Prime Minister Narendra Modi’s first term). This is in sharp contrast to the intransigent attitude of the banking regulator under similar circumstances in the past.

During the four-and-a-half years of Modi 1.0, despite inflation, as represented by the Consumer Price Index (CPI) remaining within the target range of four per cent (+/-2 per cent) on either side, the RBI refrained from making any positive moves to lower the policy rate.

Prior to January 2015, the RBI, under the then Governor, Raghuram Rajan, followed a hawkish policy. Consequently, the interest rate had reached a high of eight per cent. Thereafter, even as the Government

succeeded in bringing the inflation to a low of 4.2 per cent in October, 2016, the policy rate was lowered to 6.5 per cent (of the 1.5 per cent cut during that period, the banks transmitted only up to two-third to the borrowers by way of corresponding reduction in the lending rate).

In his very first policy review announced on October 4, 2016, former RBI Governor, Urjit Patel, who took over from Raghuram Rajan, reduced the rate from the then prevailing 6.5 per cent to 6.25 per cent. However, in the second review (December, 2016), he kept the rate unchanged at 6.25 per cent despite inflation staring at 3.6 per cent in November, 2016, which was significantly lower than the target rate. In the February, 2017 review, too, the policy rate was kept unchanged even as the CPI continued its downward trajectory to 3.4 per cent in December, 2016 and further down to 3.2 per cent in January, 2017.

During the fiscal 2017-18, inflation was in the 2.0-3.5 per cent range during the first half and 4.2-4.6 per cent during the second half — this was well within the target range. Yet, during that period, only once ie, August 2017 review, the rate was reduced to 6.0 per cent. During the first half of 2018-19, the rate was upped by 0.5 per cent in two rounds — 0.25 per cent each in June 2018 and August 2018 respectively. This despite inflation during the first half registering 4.7-5.1 per cent — though slightly higher than previous year — but well within the permissible six per cent on the upper side of the band.

The above trends clearly point towards the RBI’s obsession with inflation management even as it was completely oblivious to the overarching need to push growth, that too at a time when the economy was struggling to cope with the sudden disruption caused by the twin reform measures viz, demonetisation (November 2016) and the Goods and Services Tax), implemented from July 1, 2017.

Or else, how does one explain its unwillingness to go soft on the policy rate even when the inflation was well within the range set by none other than the central bank itself? In fact, in a bid to lend some legitimacy to what it did, it even erected a facade of inflationary expectations, which was not warranted (in fact, the upside risk to inflation — as anticipated by the MPC — was not borne out by facts on ground zero as amply demonstrated by the CPI consistently keeping low all through).

Here, it needs to be recognised that the relationship between inflation and interest rate is tenuous. To understand this, let us assume that inflation is higher than the target range. Going by the RBI’s logic, the policy rate ought to have been increased. Will that help in reining in inflation? The answer will be an emphatic no.

About 50 per cent of the CPI includes food items. It will be fallacious to argue that higher cost of credit will prompt people to reduce their demand (this is largely a function of the calorie intake apart from the fact that normally no one ever borrows money to finance purchase of food). Food inflation is mainly a function of supply. If there is disruption in supply, then price will rise, irrespective of whether the interest rate is low or high.

On the other hand, if supply is managed well, then inflation can be tamed (this indeed has been the case for most part of the period under discussion) even with low interest rate. The same logic applies even to non-food items, though to a lesser extent.    

Likewise, if inflation rises due to increase in international prices of crude oil (India sources about 83 per cent of its requirement from import, even as the price is determined by fluctuations in the global demand-supply balance), there is little that a hard interest rate policy can do to mitigate its effect.

Now, with a looming threat of a flare-up in the Persian Gulf (courtesy the stand-off between the US and Iran over the nuclear issue and the decision of the OPEC countries — fully supported by Russia — to cut supplies by 1.2 million barrels a day), the price could be heading for a sharp increase.

There is no way that India’s monetary policy could help mitigate its adverse impact. The only way the Government can succeed in combating this is by increasing domestic production of oil (besides gas), thereby reducing its dependence on import of these essential items. But the result of such a strategy will only be available in the long run. 

The message is loud and clear: The RBI should avoid being glued to targetting inflation all the time. Instead, interest rate policy should be dovetailed to propel growth. If the rate is lowered alongside pumping liquidity in the system, this will help industries and services, hamstrung by low demand, to improve their utilisation rates and even go for fresh investment, giving a boost to growth.

Unlike Prime Minister Narendra Modi’s first term, when growth was led primarily by heavy capital expenditure by the Government, in the present scenario, a big boost to private investment and consumption is needed to revive the sagging numbers. This calls for a lower interest rate regime. The RBI has done well by recognising this and even handing out a cumulative cut of 0.75 per cent in less than six months. It promises more by committing to a change of stance to ‘accommodative.” Hopefully, this trend will be sustained.

(The writer is a New Delhi-based policy analyst)