Redundant rate cut

The Monetary Policy Committee in its first bi- monthly resolution on April 4, 2019 for the current fiscal has reduced the policy repo rate by 25 basis points. Two months earlier on February 07, 2019 the MPC made the same rate cut of 25 basis points. Thus, cumulatively, there has been a rate cut of 50 basis points. The monetary policy stance remained neutral. The market expectations were on the range of 25-50 basis points and there was even a clamour in some quarters for a change over to an accommodative policy stance.

The case for the rate reduction was based on the benign inflation outlook and the intention was to move the economy to a higher growth path. However, there are upside risks in the inflation outlook. These include: (a) Probability of El Nino effects in 2019, (b) risks of sudden reversals in vegetable prices and (c) sustainability of lower fuel inflation.

The decision to reduce the rate was finalised with a vote of 4:2. The primary guiding force for the rate cut was to “strengthen domestic growth impulses by spurring private investment which has remained sluggish.”  Furthermore, as set out in the MPC resolution the following factors induced the majority vote (a) a continuous decline in headline CPI inflation rate since October 2018 and a rate of 2.6 per cent in February 2019, (b) benign inflation outlook of 2.4 per cent in Q4 of 2018-19; 2.9-3.0 per cent in H1 of 2019-20 and 3.5-3.8 per cent in H2 of 2019-20. It may be noted that  at this level the rate is lower than the mandated rate of an average 4 per cent; (c) lower and benign inflation outlook provided some space to support economic growth in the context of a negative output gap(an output gap means actual the output is lower than the potential output); and (d) moderation in inflation expectations measured by the Reserve Bank’s inflation expectation survey by 40 basis points each for the three and one year ahead horizon over the previous survey.

The case for the rate reduction was based on the benign inflation outlook and the intention was to move the economy to a higher growth path. However, there are upside risks in the inflation outlook. These include: (a) Probability of El Nino effects in 2019, (b) risks of sudden reversals in vegetable prices and (c) sustainability of lower fuel inflation.

One of the moot contextual questions in the context of policy repo rate reductions is whether the rate reduction will result in bank lending rate reductions and thus encourage private investment? As mentioned by RBI Governor Shaktikanta Das in his press briefing the 25 basis point reduction in the policy rate has only resulted in a 10 basis points reduction in the bank lending rate.

The monetary policy root to the revival of growth has its limitations as there are impediments to the interest rate transmission from short term interest rate to longer term mainly due to higher gross borrowing requirements by the government which perforce puts pressure on the interest rate.  A sustainable increase in growth trajectory should be based on a sustainable increase in savings in the economy.

There are uncertainties prevailing in the economy due to (a)ambiguities around the ensuing elections and a new government, (b)presentation of the regular budget, (c)RBI’s regulatory decision and action on the IBC resolution after a Supreme Court ruling quashed it(d)an elevated level of core inflation( head line inflation excluding food and fuel), (e) impact of a possible slowdown in the global economy affecting both advance and emerging market economies (f) volatility in the financial markets due to lower global growth and trade uncertainties and (g) a weak fiscal situation at the Central and State government levels.

The monetary policy root to the revival of growth has its limitations as there are impediments to the interest rate transmission from short term interest rate to longer term mainly due to higher gross borrowing requirements by the government which perforce puts pressure on the interest rate.  A sustainable increase in growth trajectory should be based on a sustainable increase in savings in the economy. Fiscal development with the persistence of a higher revenue deficit is continuously working as a drag. As long as the revenue deficit persists it pre- empts borrowed resources for growth induced expenditure. Thus, there is an urgent need to eliminate the revenue deficit. But, unfortunately the FRBM act 2018 has not focussed on the elimination of the revenue deficit.

The MPC resolution has not been unanimous in rate reduction. In February and as is the case now two members have chosen a status quo. But four members have voted for a change to reduce by 25 basis points. Is it a sign of maturity? Is it always correct to assume that the decision of the majority is the right decision? These are issues which need to be discussed and debated.

The decision of the MPC of a rate cut to revive growth is more theoretical than pragmatic. There are structural weaknesses in the banking system in terms of loan disbursal coupled with the higher level of NPAs. The financial market has not matured enough for a complete transmission of the monetary policy. It may not therefore be rash to say that two successive rate cuts seem redundant and could be an exercise in waste rather than an exercise aimed at the revival of growth.

In the above context the reduction in inflation in the recent period is more technical than real. As argued above there are the possibilities of downsize risks to the reversal of inflation outlook.  Furthermore, the decision of the MPC of a rate cut to revive growth is more theoretical than pragmatic. There are structural weaknesses in the banking system in terms of loan disbursal coupled with the higher level of NPAs. The financial market has not matured enough for a complete transmission of the monetary policy. It may not therefore be rash to say that two successive rate cuts seem redundant and could be an exercise in waste rather than an exercise aimed at the revival of growth.

Assuming that the RBI monetary policy stance will be neutral (neither accommodative nor tightening) and with a normal monsoon coupled with benign food  and  fuel inflation the headline inflation and the average retail inflation continues to remain around the mandated target  rate of 4 per cent. A move to a higher growth trajectory depends more on strengthening prudent fiscal management (elimination of the revenue deficit) and labour reforms and strict monitoring of loan disbursal by the banking system. Too much dependence on monetary policy interventions through rate reductions may not be helpful.

(The writer is a former Central banker and faculty member at SPJIMR)