Let me quickly establish the assumptions on which my case for the best course of monetary policy going forward rests. First, inflation might be headed northwards over the next few months but at this stage, the slowdown in growth has to be given priority in setting policy. Second, the flexible-inflation targeting regime might have been associated with a sharp fall in inflation but it is about time we recognise the fact that the rigidity that it has brought into monetary management is perhaps not entirely desirable given the current state of the real economy.
Thus, it is imperative to take advantage of whatever degrees of freedom this framework offers the Reserve Bank of India.
What about the counter-argument that a quarter of percentage point cut in the policy rate is hardly going to rev up the growth engine? That might be true in a superficial sense, but in the present situation (where an annual average growth rate of less than 6.5 percent seems quite likely for the current year), the economy could do with all the help it can get. But how can it help? For one thing, we tend to forget that any move toward monetary accommodation, particularly a rate cut, can have a positive impact on sentiment – both for the consumer and industry – and that can, at least at the margin, make a difference to their spending behaviour. This is critical for growth.
Also, the objective of a rate cut need not necessarily be to create a wedge between the cost of and return on capital sharp enough to induce the private sector to suddenly start investing in capacity. If we look at the experience of the United States after the financial crisis of 2008, there is enough reason to believe that balance sheet repair for both households and companies appear to benefit from an exceptionally low interest rate environment. Thus if we believe that the Indian economy is, as is widely believed, in the throes of a ‘balance-sheet slowdown’, lower interest rates are the panacea.
I have another bone to pick with some of the commentators writing on macro-policy and indeed the RBI itself. The strange narrative that has emerged over the last half-decade or so implicitly talks of a curious bifurcation of roles – that fiscal authorities (central and state governments) are responsible for growth, while the RBI deals with solely with inflation. This needs to go.
The RBI Is Capable of Influencing the Growth Rate and Should Be Proud of It
In fact, if it was incapable of impacting on growth, it would – going by the textbook – have little or no impact on inflation.
In short, we need a coordinated fiscal and monetary stimulus. Again, remember what the US did to get out of the post-financial crisis recession.
The notion that whenever there is any attempt at fiscal stimulus, the RBI is obliged to poop the party and tighten the monetary levers to prevent an imagined inflation spiral is sheer dogma.
So What Should the RBI Do?
Clearly, the optics of headline Consumer Price Index inflation is likely to be unfavourable going forward. However, a large part of this of this will be due to a base effect, as inflation started collapsing at this time last year. The RBI can get some room to manoeuvre if it chooses to ‘look through’ this statistical effect. This might mean that the 4 percent headline level that the RBI obsesses over will be breached but its mandate gives it the leeway to let inflation rise all the way up to 6 percent. It should take full advantage of this.
Is this likely to happen? I suspect not, at least in the October policy. The RBI will very likely choose to wait and watch and reiterate its commitment to willy-nilly ensure a 4 percent headline print for inflation. It will put the growth ball in the government’s court and yet warn of the risks of fiscal expansion. I can only hope that sometime during the rest of the year, they find the room to take a more benign view on growth.
(This article was originally published in BloombergQuint.)
(Abheek Barua is the chief economist and a senior vice president at HDFC Bank. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)
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