Rajan has the final say on rate cut
The Reserve Bank has left its monetary policy unchanged. The repo rate, cash reserve ratio (CRR) have also been left untouched. The central bank’s current monetary policy stance, therefore, stands on the side of caution. Is it justified?
On Monday, the Union finance secretary emphasised that the Indian Financial Code (IFC), revised and updated, did not intend to curtail the central bank’s powers of setting monetary policy. The IFC had suggested the creation of a panel to set interest rates and take away the RBI governor’s veto powers. Besides the proposals presented in the IFC draft, the government had also suggested the need for a rate cut now.
In fact, the Union finance minister has been suggesting that an urgent rate cut is required to revive the economy. However, the finance minister’s demands seem to have fallen on deaf ears. The current round of monetary policy formulation has to be seen in the light of a rift, once again, between the finance ministry and the RBI governor.
In fact, while the distribution of rain during the current monsoon season still remains a little unclear and its effect on the farm economy uncertain, the central bank could not have taken a very decisive move either way. It has not raised the rates, despite the fact that prices have begun to rise once again. In addition, the central bank has not cut rates, as demanded by members of the government and industry.
From a detailed reading of the RBI’s statement, it looks as though the biggest factor holding the central bank back from lowering rates is the potential inflation. The RBI has underlined the “most worrisome is the sustained hardening of inflation excluding food and fuel”.
Expressing its caution, the RBI pointed out several factors which bear some examination. Its policy stance appears to have been taken on basis of four factors: Banks have yet to fully transmit its earlier rate cuts, since they have transmitted only 30 bps of its 75 bps cuts so far; it continues to monitor supply side food management and the full impact of monsoon; government efforts to unclog supply side constraints like land, power; and global developments like US Federal Reserve Bank rate hike.
Commercial banks have not been forthcoming in introducing rate cuts as a follow-up to RBI’s moves. Even when the RBI introduced rate cuts, the banks did not follow suit. What then is the justification of a rate cut by the central bank? The policy change, thus, has failed to get transmitted.
The banks for their part have pointed out the structural problem with deposit rates. If a good part of their funds are from long-dated fixed deposits, then a rate cut can cut away banks’ profitability. The banks have to wait until their deposit rates also get adjusted. They should be given that time to adjust.
Secondly, their experience with bad debts also presents an important factor. Even when having surplus funds, banks have tended to seek the easy way out. They put money into government securities and do treasury operations to earn money. Instead, they could have increased their lending with lower rates. However, the fear of incurring more bad debts does have a bearing on banks increasing their loan portfolio. Therefore, the banks need to change their modus operandi as well.
As for the current inflation trends and the dynamics of inflation, these are not too reassuring. The latest inflation figures increasingly show a broader kind of inflation. While the past few months show inflation pressure across the board, with crude prices coming down, reasonable monsoon showers and large food grains stocks, which can cushion any increase in basic food grains prices, the chances are that price rise should moderate in the coming months.
The RBI has set the inflation rate at 6% and it is by and large on its targeted path. The RBI, therefore, could have been less pessimistic in its inflation projections and risk a little more by introducing some rate cuts. This is all the more warranted since RBI growth projections remain anchored at 7.6%, as previously stated.
The RBI has noted that several sectors of the economy are not doing too well. Investment has not picked up as measured by new projects. Capacity utilisation remains flat and, therefore, fresh investment in capacity creation will be sluggish. Consumption demand is also not rising as revealed in the sales figures of interest-sensitive sectors like housing or automobiles. The RBI has noticed these disabilities in its policy statement. And yet, it refuses to step in with corrective measures!
Unlike the RBI, most central banks are proactive, pushing for monetary measures to buck up their economies. Quantitative easing was started when conventional monetary policy tools were blunted with interest rates remaining at zero. This was subsequently taken up by the US Federal Reserve. Now, Bank of Japan and European Central Bank are in the midst of massive easing programs to give a boost to demand and growth. Why is the RBI so conservative in its approach?
Could it be that hammered by the government and pestered by industry, RBI is bent on asserting its independence? Is it pursuing a policy path to demonstrate that it is the supreme authority in deciding the rates? Differences between the central bank and government are not unknown. In fact, these are normal. But maybe, the government is queering the pitch in its efforts to somewhat pushing the central bank into a corner. IPA