October 04, 2015

Interest Rate Cut A Matter of Interest

C P Chandrasekhar

RESERVE Bank of India (RBI) governor Raghuram Rajan has surprised all by a “bold” 50 basis points (or half a percentage point) reduction in policy (interest) rates. The interest rate payable on borrowing by banks from the RBI (or the repo rate) has been brought down to 6.75 percent and the interest rate banks get when they hold deposits with the RBI (or the reverse repo rate) has been reduced to 5.75 percent. The idea is not merely to reduce interest rates charged to borrowers, but to push banks into lending more rather than holding large cash reserves. This is surprising because the governor had in the recent past held out against pressure to reduce policy interest rates, on the grounds that cheaper credit could spur inflation. Though the rate of inflation has come down, it argued, that decline was because of special factors (such as the international price of oil) and the potential for further inflation remained high. So erring in the direction of preventing inflation rather than spurring demand and growth was the appropriate policy in its view.

As opposed to this, the objective of the recent rate cut, whether realised in practice or not, is different and clear. It is to increase access to cheaper liquidity so that debt-financed investment, housing purchases and consumption would revive and growth would accelerate. So, clearly, the governor has changed his view and now considers growth, rather than inflation, the bigger problem to address. It is indeed true that the annual rate of CPI-based inflation in August (relative to August of the previous year) was, at 3.66 percent, within the RBI’s “target” range. But the decline in the rate of inflation has been with us for sometime now and this year’s poor monsoon threatens to trigger food price inflation. So the RBI governor does seem to have changed his view.

Further, Rajan had strong views on the relative roles of the central bank and the government. The RBI he seemed to believe should focus on targeting inflation, while the government by resorting to deregulation that removes “impediments” to investment and ensuring a stable macroeconomic environment by realising its fiscal deficit reduction targets, should be responsible for growth. That too has changed now. In a clear turnaround, the governor in his monetary policy statement has admitted that it is time now to revive demand and held that a signal that the RBI is committed to providing a monetary stimulus would revive investment and growth. For that reason, he argued, “the Reserve Bank has front-loaded policy action by a reduction in the policy rate by 50 basis points”.



This dramatic shift in perspective and change in policy stance of the RBI is bound to be seen as a sign of the RBI accommodating or submitting to the government view, expressed by Finance Minister Arun Jaitely and his team, that stimulating growth requires a monetary stimulus. The stimulus here is not just the direct effect that the reduced cost of capital is expected to have on investment. Investment can be quite unresponsive to interest rates, if demand is slack. So the real intention is to spur demand by making it cheaper for households, corporates and other economic agents to borrow and spend. The idea is to put India back on to a strategy where debt-financed demand stimulates a revival.



Implicit in this stance is the admission that the GDP growth rates, which, though lower than earlier, are still high, do not reflect the true state of the Indian economy. Hence  the reference to “still-low industrial capacity utilisation” and the need for more domestic demand “to substitute for weakening global demand”. The RBI governor went even further, and made a case for a fiscal stimulus when he said that “public expenditure on roads, ports and eventually railways could … provide some boost to construction” and that the implementation of the Pay Commission’s recommendation (which would stimulate demand) is not likely to be inflationary, so long as fiscal deficit targets are met.

However, this obsession with fiscal deficit targets may be the government’s undoing. With the government unlikely to raise direct taxes to mobilise revenues to finance its expenditures, any increased spending on infrastructure, for example, when deficit targets are met, would amount only to a change in the composition of government-induced demand growth, not its volume. It is the latter that is important in the current circumstance. This is specially so since the evidence is that fiscal rather than monetary stimuli are needed for growth. So expecting the economy to revive only because the RBI has cut interest rates may be wishful thinking. In fact, a problem in recent times is that India’s banks, seeking to deal with their large non-performing assets and improve their balance sheets, are not just unwilling to lend as before, but are also unwilling to pass on a significant share of the benefits of any reduction in interest rates (or the cost of their capital) to their customers.

In sum, the “surprising” move by Rajan is unlikely to serve its intended purpose – that of reviving growth. All it does is signal that the RBI too recognises that the threat in India today is not inflation, but deflation, where a combination of falling inflation and falling demand could precipitate bankruptcies, which would depress demand further and set off a vicious cycle.

Not wanting to be held responsible for any such outcome, Rajan has decided to drop his ideological inclinations and reverse his policy stance. This, however, is not surprising. In the past too Rajan has displayed an ability to signal that he is on both sides of positions that are in conflict. Because of a Jackson Hole address delivered by him, he is seen by some as one who is cautious about financial development spurred by deregulation and, more importantly, one who “predicted” that the consequences of deregulation would precipitate a 2008-type financial crisis in the US. But, when in India, the report of the Committee on Financial Sector reforms that he headed, which submitted its report when the global crisis was unfolding, had recommended deep and wide-ranging deregulation and expansion of the financial sector in India. That is what you would expect of a former Director of Research of the IMF. But, Rajan has managed to ensure that the reputation he carries is still heavily influenced by his Jackson Hole address.