S S Tarapore

No case for lowering interest rates

SS TARAPORE | Updated on January 22, 2018 Published on September 16, 2015

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An accommodative monetary policy is not a great idea when inflation expectations are firm and savings rates low

The Reserve Bank of India’s fourth monetary policy review is due on September 29. While 25 years ago we were essentially a closed economy, we are now significantly integrated with the world economy and hence global developments strongly impinge on India.

Ever since the international financial crisis of 2008, the global economy has gone on a binge of large borrowing and low interest rates as if there is no tomorrow. Erudite analysts would tell us about the woes of the euro area and Japan and how the disease is spreading to the emerging market economies (EMEs). How will history judge the global policymakers of today? Years of low interest rates combined with lethal quantitative easing has not restored the global economy back to robust health. Internationally recognised intellectuals would snigger at any mention of a Kondratieff long cycle of low or negative growth, yet that is where the global economy is headed.

Silent Yellen

Among the industrial economies, the US has been the least affected and the US authorities have for quite some time recognised that it is time to undertake the first increase in interest rates since 2006. Influential policy honchos have been urging that the US should refrain from raising interest rates on September 17.

Some members of the Federal Open Market Committee (FOMC) have voiced concerns that it may be too early for the US to raise interest rates as it may abort the nascent recovery in the US and, moreover, worsen the situation in the poorer performing industrial countries as well as the EMEs.

The US Fed chairperson, Janet Yellen, has been noticeably silent. Stanley Fischer, vice-chairman of the US Fed, has explicitly stated that it is time for the US to consider an increase in interest rates. Speaking at international fora, RBI governor, Raghuram Rajan, has articulated that countries which have had a distinct accommodative monetary stance should reverse the process by a calibrated increase in interest rates.

When it is unclear as to what path economic policy should take, the best approach is to get back to basics, that is, course Eco 101. It is unfortunate that these days, the economic thought of the past is given short shrift. Present policymakers would do well to recall the wisdom of the masters of yore. The great teacher, Gottfried Haberler, in his celebrated Prosperity and Depression (1937) made an immutable statement: “The seeds of depression are sown in the preceding boom.” The Nobel laureate, FA Hayek, in his over-investment theory of the trade cycle explained that monetary tightening should be undertaken during the uptrend of the cycle and any tightening after the upper turning point of the cycle would only aggravate the downturn. If only today’s economic pundits had imbibed this lesson, they would be advocates of early monetary tightening by the US Fed.

Indian macro situation

The Indian macroeconomic situation is admittedly complex but a few parameters need to be carefully examined. While there are questions about the new GDP numbers, suffice it to say that the current year’s GDP growth would be at least 7.0-7.5 per cent. Of course, cheer squads led by Arvind Panagariya, vice-chairman of the Niti Aayog, would aspire to attain an 8.0-8.5 per cent growth rate in 2015-16. Even at the lower projection of 7.0-7.5 per cent for GDP growth in 2015-16, India would have the highest growth rate among both industrial economies and EMEs.

Pushing the growth frontier further may make for good political economy copybook but by growing beyond the potential with inappropriate policies would only invite a sharp downturn.

In contrast with our sensitive reaction to lower GDP rates, the Chinese authorities are explicit that they see lower GDP growth as desirable in the context of consolidation of the economy. We in India need to take serious note of this approach.

With the year-on-year consumer price index (CPI) showing an increase of 3.66 per cent on a year-on-year basis as of August 2015, and the wholesale price index (WPI) showing a year-on-year inflation of minus 5 per cent, the protagonists of a reduction of interest rates are demanding not merely a 0.25 percentage point reduction but a full percentage point reduction in, say, two quick steps.

Arvind Subramanian, the chief economic adviser in the ministry of finance has queered the pitch by arguing that the CPI is not the appropriate indicator for inflation and that we should use the GDP deflator or the gross value added (GVA). The government and the RBI in February 2015 formally signed an agreement on the monetary policy framework indicating that the CPI would be the indicator for inflation.

As Rajan has pointed out, monetary policy has to take into account anticipated inflation and this does not hold any hope for continued low inflation rates. Moreover, apart from the year-on-year inflation rate, it is necessary to take into account the level of inflation which, at the present time, is unusually high.

Savings rate

The gross domestic savings-GDP ratio is now around 30 per cent and any further fall in interest rates will result in a shift away from financial savings.

Even prior to the September 29 announcement, banks have sharply reduced deposit rates and any further reduction in deposit rates will result in a major shift from financial to physical savings. The authorities must bear this in mind while deciding on any further reductions in interest rates.

Irrespective of what the US Fed does on September 17, the RBI should not relent on the interest rate issue on September 29. We ought to be concerned about the impact of lower interest rates on capital flows and the shift from financial savings to physical savings. Rajan will provide a signal service to the country by not reducing policy interest rates or relaxing reserve requirements.

On this occasion more than others, the question all want to ask Governor Rajan is: Quo vadis? (Where are you going?)

The writer is a Mumbai-based economist

Published on September 16, 2015
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