MAVERICK VIEW. Policy in the age of secular stagnation

The monetary policy framework agreement signed by the Union Government and the Reserve Bank of India (RBI) on February 20, 2015, will shape the stance of monetary policy in 2015-16 and successive years.

The RBI will stay focused on ensuring that the economy disinflates gradually and durably, with Consumer Price Index (CPI) inflation targeted at 6 per cent by January 2016 and at 4 per cent by the end of 2017-18. The target for end 2017-18 and thereafter is defined in terms of a tolerance band of plus or minus 2 per cent around the mid-point; it will be the RBI’s endeavour to keep inflation close to the mid-point.

The RBI’s projected path for 2015-16 is for inflation falling to 4 per cent by August 2015 but thereafter firming up to 5.8 per cent by the end of 2015-16. While the agreement marks a watershed, setting out specific figures for August 2015 and March 2016 in the monetary policy of April 7, 2015, leaves one with an element of discomfort.

As part of the press conference and the conference with analysts after the announcement of the policy, it was explained that the RBI would be monitoring the inflation rate through the year.

Nonetheless, neither the policy statement nor the monetary policy report for April 2015 have precisely set out how the failure to achieve these targets for three consecutive quarters will trigger accountability. Is the 4 per cent plus or minus 2 per cent band to be assessed as an average during the year or will a deviation be determined when the band is exceeded in any month during the year in three successive quarters?

This is best clarified explicitly up front, lest analysts/media, or for that matter the government call for an explanation from the governor.

Despite the noise by industry that interest rates should be reduced, the RBI on April 7, appropriately left unchanged the repo rate (7.5 per cent), as also access under the repo facility, as well as the cash reserve ratio (4 per cent). The RBI threw the ball back into the court of the banking industry which had not responded to the two earlier repo rate cuts by the RBI.

Unlike in the 1990s when the RBI would explicitly advise banks to reduce/increase interest rates, during the past decade or more, the RBI has not used strong suasion to make banks alter interest rates. In this context Governor Raghuram Rajan’s explicit advice to banks was unusual. Banks, after a very brief resistance, reduced deposit and lending rates.

With the imperative need to step up household sector financial savings, and with bank deposits accounting for 60 per cent of household sector savings, further reduction in deposit rates could drive term deposit holders away from banks.

While deposit growth in the recent period has been relatively low, it bears repeating the Rangarajan dictum that disintermediation does not affect the level of deposits but its composition. The level of deposits is not determined by the extent of disintermediation but by the real growth of the economy, the inflation rate, reserve money (RM) creation and the RM/M3 multiplier as also the split of M3 between deposits and currency.

It has long since been recognised that for a well developed government securities market with depth and liquidity it is necessary to have different players with different perceptions and different liquidity needs. While mutual funds and foreign institutional investors have, in recent years, entered the government securities market, individual investors have been virtually absent. This was not always so.

In the 1940s and 1950s, individuals accounted for a very large proportion of the government securities market but individuals disappeared from this market from the 1960s onwards. This was because of a number of factors. First, g sec interest rates are not really market determined as banks and institutions are subject to pre-emptions. Secondly, the government offered savings bonds for relatively short maturities at 6.5 per cent (tax free) or 8 per cent taxable but these schemes have now been withdrawn. Thirdly, while dedicated gilt mutual funds have been set up, a large part of such funds is accounted for by institutional investors. Fourthly, the yield curve is flat and at times inverted.

The days of direct individual investments in government securities are over. Today, it is dedicated gilt mutual funds, exclusively for individuals, which is the way of developing individual interest in government securities. For this, interest income of individuals from government securities should be fully exempt from the Dividend Distribution Tax (DDT) which is presently 28.33 per cent per cent. This is not a new suggestion. The RBI had made this suggestion 20 years ago and the department of economic affairs had supported this idea, but the revenue department shot it down.

The monetary policy report, April 2015, has an interesting box ( pages 32-33) which shows that despite accommodative monetary policies for a long period of time, the global economy appears to be suffering from secular stagnation, wherein there is a low level equilibrium trap of low investment and low potential growth.

In other words, the slowdown is a structural phenomenon rather than a cyclical outcome of the global financial crisis As such, monetary policy is, by itself, unable to raise potential output. A tantalising thought is that the global economy is possibly caught in a longwave Kondratieff cycle of 50-60 years of low growth. Poor Nickoli Kondratieff — the Russian economist who developed this thesis was denounced by both the Soviet Union as also the western capitalist economies, and eventually shot in 1938. He would be smiling in his grave.

The writer is a Mumbai-based economist. His very first article in BL, ‘Drowning in liquidity’, (November 7, 2008) referred to the Kondratieff cycle

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