Recently, the Monetary Policy Committee (MPC) of the RBI reduced the repo rate by 0.25 per cent, thus bringing it down to 6 per cent. In its previous meeting too, it reduced the repo rate by 0.25 per cent.
The repo rate is the rate at which banks borrow from the RBI. Depending upon this, the bank’s lending rates are decided. Therefore, reduction in the repo rate paves the way for lowering of interest rates—the rate at which people can borrow from banks for their consumption and investment needs. In the past, the MPC was resistant to the idea of reducing the repo rate citing inflation targeting; there were demands from various quarters, including the Centre, asking the RBI to reduce the repo rate to ease flow of credit.
It has to be noted that the MPC has been obsessed with inflation targeting while deciding interest rates, ignoring even growth. Given this MPC has chosen a band of
4 per cent plus/minus 2 per cent inflation. Before the constitution of MPC, it was decided to use Consumer Price Index (CPI) rather than Wholesale Price Index (WPI), for inflation targeting, on the basis of the recommendations of a committee under the chairmanship of the then RBI Deputy Governor Urjit Patel in 2014. This change impacted the decisions of the RBI about inflation targeting then, as there was a huge difference between CPI and WPI. Notably, CPI had greater weight of 46 per cent for food products compared to only 30 percent (including manufactured food products) in WPI. Food inflation used to be much higher then, and therefore, repo rate based on CPI inflation targeting continued to be high despite cooling down of WPI-based inflation. However, in the last three years of the NDA government, even CPI has fallen significantly, and has remained low, at less than 3 per cent.
However, initially, the RBI governor and later even the MPC continued to undermine falling inflation, based on their inflationary expectations. They say there is danger of spike in inflation. They therefore refused to reduce to the repo rate in the name of inflation targeting based on their expectations about inflation, which continued to be proven wrong in every subsequent review.
Therefore, one can say that repo rates were kept high not because inflation was high or there was a real danger of inflation in the country, but because the RBI maintained its stance that inflation may go up. However, the MPC was not ready to mend its methodology to determine its stance.
It’s acceptable that while determining repo rate, we must ensure that real rate of interest remains reasonably positive. Real rate of interest is the nominal (that is, rate of interest prevailing) minus rate of inflation. We know that in 2013, repo rate was 7.75 per cent, while rate of inflation was 11 per cent; thus the real rate of interest used to be negative. However, since then inflation rate came down to less than 2.5 per cent in 2018, while the same is not true of the repo rate, which remained between 6 per cent and 6.5 per cent. That exactly is the issue, that real rate of interest remained between 3.5 per cent and 4 per cent.
If repo rate increases, it will increase cost for banks borrowing from the RBI. On the one hand, the MPC aims at keeping repo rate high, targeting inflation. Businesses would always want repo rate to go down, so that they can reduce their cost of borrowing. For household borrowers, their EMI on housing and other consumer loans would drop. Fall in interest rates also helps in promoting infrastructure growth.
It is important to note that in the past six-seven years, investment has not been picking up, resulting in lower capital formation, which was 39 per cent of GDP in 2011-12. It has come down to 32.3 per cent in 2017-18. Based on the past experience, high rates of capital formation coincides with lower interest rates.
Inflation targeting by monetary authorities is fine, but having opinions, which are proved wrong repeatedly, raise doubts about the direction of the monetary policy and therefore need serious rethinking. It is notable that the MPC in its April 2019 meeting has continued with its ‘neutral’ stance, which it adopted in its earlier meeting on February 2019, shifting from the stance of ‘calibrated tightening’. In that meeting too MPC had reduced repo rate by 0.25 per cent. Though, MPC has reduced the repo rate by 0.5 per cent since February, it was expected that it would have changed its stance to ‘accommodative’. This is so because the global economy is showing signs of slowdown and indicators show that consumer demand in the country is also not picking up. The same is the case with investment demand.
Given the fact that inflation is low for so long, and economic activity is constrained due to high interest rates, the MPC should have changed its stance to accommodative to give a policy guidance as per the need of the hour. Markets were expecting a change to accommodative as global banks have also adopted a dovish stance about monetary policy in their respective countries.
The MPC needs to understand that apart from inflation targeting, they also have a duty to give a boost to growth and be accommodative when the situation is ripe. It had all the reason to do so given the weakening of domestic demand—both consumption and investment— with inflation remaining consistently low.
Ashwani Mahajan
Associate Professor, PGDAV College, University of Delhi
Email: ashwanimahajan@rediffmail.com