Propagating An Interest Rate Cut (Yet Once Again…!!)

Wrote this piece (click here) for FirstPost on why the RBI should start cutting interest rates immediately instead of waiting for inflation and inflationary expectations to subside. Someone commented that it might be better to wait for inflation to disappear before taking the shears to interest rates. Most other economists have also been echoing the same sentiment: it’s better to first squeeze out inflation from the system (albeit with the help of only monetary policy) before easing the tight monetary system.

My only take is: a large component of inflation in India arises due to supply side issues. These have been lingering for decades and no solution seems to be forthcoming. I don’t expect the Government to sort these out in a hurry. Given the fact that these structural deficiences are likely to be with us for some more time, we are left with only two choices.

One of them was articulated by RBI Governor D Subbarao in an interview to Wall Street Journal (read here). According to him, the non-inflationary rate of growth for India is around 7% — in other words, any rate of growth beyond the 7% might get the engine to overheat and cause inflationary smoke to billow from below your bonnet. Somewhat like what has happened in the past 24 months or so. If as an economy, we are content with a 7% GDP growth rate (which, by the way, if infinitely superior than most other countries), then the current economic prescription seems just right.

However, as many studies have repeatedly shown, India needs to grow by at least 8-9% every year, for some more years, to sort out one of its endemic problems — poverty. And, to grow at that rate, the economy needs a much higher level of investment. There are many reasons why investment growth has slowed in the current context — scams, bureaucrats getting ultra-cautious, approvals not forthcoming, governance lapses stemming from the country’s top-most office, uncertainty over the policy environment, and, high interest rates. While the government is trying to re-set the investment climate by making the right noises about policy and project approvals, these will have to viewed by industry as sustainable in the long-term before they start committing their cash all over again.

In the meantime, interest rate hikes by the RBI have had a greater demonstration effect. Since interest rates are far more visible and tangible, they have earned a disproportionately larger share of the blame for the economic slowdown. Therefore, if the RBI cuts interest rates now — even if it’s by only 25 bps — it has enormous demonstration effect and has the potential to kickstart the revival process.

This is not to say that the inflation problem is trifle. But there is a limit to which monetary policy can sort out inflationary pressures arising out of government profligacy and neglect.

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One thought on “Propagating An Interest Rate Cut (Yet Once Again…!!)

  1. Well put, Rishi. I have been maintaining that it is RBI that gives second wind to inflation with unwanted and irresponsible hikes in interest rates. They raise the floor on interest rates when they raised interest rates on savings rather than bring it to zero. Supply side is screwed thanks to fear and global uncertainty. Unless there is no incentive to sit on cash, supply side is going to be the bottleneck.

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