Unfortunately, our political bosses are either unaware of their power to revive economic growth or perhaps they’re too reluctant to use it now
The Monetary Policy Committee (MPC) decided to cut interest rates by 25 basis points (BPS) on October 4. With this, we’ve seen a cumulative slash of approximately 135 BPS. Yet, our real interest rates are at two per cent, which is still 75 BPS above the MPC’s own stated neutral real rates.
A neutral real rate is that at which the monetary policy is neither expansionary nor contractionary. At a lower rate, the policy tends to be expansionary, having a positive impact on growth and at a higher rate it is contractionary, thereby preventing the economy from getting overheated.
It is precisely here that we have a problem because our real rates continue to be higher than the neutral ones, more so at a time when they’ve reduced growth from 6.9 per cent to 6.1 per cent. Therefore, despite a 135 BPS cut, we still have a contractionary monetary policy, which is precisely why we should have slashed them more aggressively.
Going by the Governor’s previous cut of 35 BPS, perhaps a 65 BPS would have been perfect at this juncture, post which we could revert to cuts in multiples of 25. The rationale for the 35 BPS cut was that 25 seemed too less and 50 seemed too much two months ago. By this logic, if after a 35 BPS slash we still saw the output gap widen, then we must see a cut that’s at least greater than 35.
Unfortunately, we saw the exact opposite and this makes one wonder the macroeconomic understanding and underlying model of monetary policy that is being used by the MPC.
Nobody believed the Reserve Bank of India (RBI) when it came with a growth forecast of 7.4 per cent and revised it throughout the year to 6.9 per cent. This recent prediction is very likely to be closer to the actual growth numbers. The important issue is where does our growth go from here, given that our real rates are still above neutral ones?
On the fiscal front, we’ve seen the Government take bold decisions, especially with respect to the aggressive corporate tax cuts. Its decision to commit to its expenditure despite a likely revenue shortfall is a sign that we’ve got a counter-cyclical fiscal policy. One more intervention that can come from the Finance Ministry is some changes in the personal tax cuts.
There is speculation and expectation of the same but we don’t have any official word yet, so one doesn’t necessarily know if it would happen or not. If it were to happen, then it would have an impact on domestic consumption.
Here’s an important statistic: In the period from 2013-2017, domestic consumption increased by 53 per cent, while personal loans were up by 89 per cent. This shows how the recent increase in consumption was financed largely by debt. The fact that our current slowdown started with the second quarter of the previous financial year, which coincided with the IL&FS crisis, is no surprise.
Non-Banking Financial Companies (NBFCs) are systematically important as they ensure last mile credit delivery in India. The IL&FS disaster resulted in a freeze in credit and an increase in the cost of capital across the NBFC space. Therefore, the present slump in domestic demand must be traced back to September 2018 and since then the Government has taken numerous measures to correct the same. Be it addressing the liquidity concerns in the NBFCs or strengthening our banking system through front loading of recapitalisation. All these moves were important and had to come from the fiscal side. The Finance Minister has pulled almost all policy levers with her to address the cyclical component of the current economic slowdown.
Unfortunately, our monetary policy has failed to deliver just at the precise moment when we need it the most. If recent consumption growth was fuelled by debt then reducing cost of credit will have a positive impact on the income of households. This impact on past Equated Monthly Installments (EMIs) and on future loans will be instrumental in the country’s economic revival.
Reduction in cost of credit, combined with the recent tax cuts would have only made Indian firms more competitive and attractive for investment.
Unfortunately, our monetary bosses are either unaware of their power to revive economic growth or perhaps they’re too reluctant to use it now. In either of the cases, our recovery will be slow despite a slew of measures announced by North Block. In a couple of months, we will find that the 135 BPS cut was not enough and the slow pace of rate cuts will only prolong the inevitable revival of our economy growth. The only question then would be the reasons behind our monetary policy fiasco.
(The writer is a New Delhi-based policy researcher)