Its Time for the RBI to go for “athletic-steps"

The debate on rate cuts have been going on in the media, as always happened prior to RBI’s policy announcement.  Expectedly, two views emerge. While economists of the business houses unilaterally argue for a rate cut, academic economists, though justified, are divided over the issue. First, some ground realities. Inflation, both actual and expected, stays high much beyond the comfort level. IIP is in a freefall! Growth rate of GDP has been shrinking. Gross fixed capital formation has also declined. Household savings rate is also declining. Central banks around the world, notably the Fed’s QE3, are going for accommodating policies. Interest rate cost of investment has gone up. Government has adopted some policy measure to rein in fiscal deficit. These diverging trends may pose serious challenge for the RBI to conduct its monetary policy that is further burdened by market expectations and frequent communications from the finance ministry.

It seems that the RBI now stands between two paradoxes. Cutting policy rates would hardly stimulate investment, as policy paralysis has much to account for this depressed investment. On the other hand, RBI has hardly been successful in taming inflation in its two and half year’s battle. Inflation, measured by month-on-month, is 7.8% in September, the highest in this year. More importantly, inflation is over 7% in a row for last 34 months staring December 2009. Assuming that it takes at least six months for interest rates to have complete impact, average inflation still stands at 8.7% for the next 21 months, thus defying RBI’s commands.  Hence, there is hardly any justification in keeping policy rates high.

The findings of 28^th round of inflation expectations survey of households for the first quarter of 2012 reveal that the percentage of respondents expecting price rise in next three-month and in next one-year have gone up. There has been a marginal increase of 30 basis points (henceforth, bps) as compared with the last round of the survey for the three month ahead and one-year ahead mean inflation expectations that stay at 12.0% and 12.8%, respectively. More importantly, 44.5% of the respondents think that RBI is ‘not’ taking right action against inflation while 43.5% feel that it is doing the right work. It does not show RBI has earned any credibility. Neither has RBI been successful in reducing inflation to its comfort zone nor has it helped reduce inflationary expectations.

RBI has hiked repo rates 13 times since March 2010. Many economists believe that this baby-step rise in repo rates has not been successful in dampening inflation. Similarly, both RBI’s surprised repo cut of 50 bps and CRR cut of 25 bps have also not helped much, as evident from the frozen IIP numbers and reducing forecast of growth.

Pursuing such a high interest rate regime for a long period might turn out to be counter-productive. As we know theoretically that when industrial prices are cost determined firms will pass these rise in costs in terms of higher manufacturing prices. And there has been evidence that the interest cost as a share of total cost is non-trivial. In fact, industrial price is very highly correlated with WPI inflation. Further, it may dent that part of agricultural investment and agricultural growth which depends upon formal credit. Hence, on both accounts, a high interest rate would be costlier to both farm sector and firm sector.

The fact that government has shown some seriousness through recent policy announcements and is doing its bit, it is a best chance for the RBI to have an unexpected larger cut. Increasing basing monetary policy on fiscal consolidation may not always yield the optimal outcome. High interest rate regime has contributed to one-third of the slowdown. But this is not a non-trivial magnitude! 

While most debates have surrounded whether to reduce rates, less attention has been given on the magnitude. RBI should go for a bigger cut. It would help test if the baby-step hypothesis, pursued by the RBI, was right. In other words, if a steep repo rate cut of 1 percentage point or simultaneously reducing repo and CRR would boost investment, then we can say that piece-meal approach of the central bank won’t help much as compared to “athletic-steps”. Further, it would be a good test to measure the effectiveness of central bank policies in the face of supply-side led inflation.

RBI’s shift from inflation fight to stimulating growth won’t signal that it has lost the battle or nor it would signal that it is shifting its ‘inflation tolerance level’, as certain columnists have argued. Instead, RBI can clearly communicate to people why it reduces policy rates and how it can have an impact on productivity that would address supply side bottlenecks. Central Banks around the world has hardly been successful in curbing inflation led by supply side factors. But this does not mean that it should not fight inflation at al. But, 24 months are enough to judge the efficacy of these elevated policy rates. Hence, it merits for a somewhat bigger cut, enough to stimulating the frozen industrial sector, and reviving growth. Finally, industrial recovery can revive the household financial savings. The decline in household financial savings rate may be attributed to expected low return from industrial sector and falling IIP numbers. Hence, they want to invest low and, save low. To prevent this RBI can launch inflation-indexed gold bonds

It would be interesting to see if the RBI is going for a bigger rate cut. But my haunch is that it would either maintain the status-quo or repo cut of 25 bps or CRR cut of 50bps. No More baby-steps Please!  Time for the RBI to go for “athletic-steps”.