Monetary policy in times of a slowdown

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The GDP numbers for Q1 coming in lower than market predictions led to worries over prospects for Indian growth, but it must be remembered that Q1 was an election quarter. The fall in investment growth visible in January was a worrying indicator of a possibly persistent slowdown. But 30 per cent of the GDP cannot be considered as ‘no investment’.

The July IIP continued to show negative growth for capital goods, although deceleration was slowing. High frequency indicators show continuing contraction in Q2. The festival quarter, Q3, will be critical. But further support is required. The RBI Annual Report concluded the slowdown is largely cyclical (and not some stubborn structural trap) — and follows that policy has to be counter-cyclical. Since the government has limited fiscal space and is focussed on improving the supply-side, the real interest must be changed enough to affect demand.

When the focus shifts from inflation to growth, it is essential to work with the effect of the real interest rate on aggregate demand (AD). The April RBI Monetary Policy Report discussed the output gap, but not AD. Early RBI estimates for the pre-global financial crisis (GFC) period gave a low and lagged real interest elasticity of AD (-0.1).

But research at IGIDR finds that the interest elasticity is as high (-0.21) as in advanced economies, if demand elasticity is estimated more correctly with the interest gap rather than just the real rate. Moreover, interest elasticity has risen after the GFC and behaviour has become more forward-looking.

The real rate should be a neutral rate at which inflation stays in the target band and the output gap closes. Currently, the one-year ahead real rate (based on the one-year Treasury Bills rate of 5.6 per cent and a 4 per cent inflation) is 1.6, while inflation is below 4 per cent and the output gap is large and negative. A 40 bps cut to 5 per cent would have taken the real rate to 1.2, which is still above neutral, but in line with the principles of FIT (flexible inflation targeting) on an accommodation path, that signalled further cuts based on how the recovery develops. But the MPC chose a conservative 25 bps cut, following arguments against large cuts.

Over-stimulus, such as that which occurred after the global financial crisis, is undesirable. The repo crash from 9 per cent (in September 2008) to 4.75 (in April 2009) — a cut by 4.25 in six months — was too much, especially as inflation remained high. However, it was effective. Together with a fiscal stimulus, it led to a sharp recovery. This counters arguments that interest rates do not affect growth.

But the current cumulative 1.35 per cent cut is probably inadequate in Indian conditions; an intermediate cut now of up to 2 per cent would have a chance. A larger cut is required in thin markets. More market development since then reduces the size of the cut required. The neutral real rate is a guide to prevent over-stimulus. This falls in a slowdown, but can remain low positive.

Factors affecting inflation

Since inflation is low, the real rate is still high and positive. There is no need to fear mean reversion of inflation – it could even persist below 4 per cent in 2020. Core inflation is also falling. The August figure came in at 4.2 per cent, while the combined CPI at 3.2 and WPI at 1.1 were far below 4 per cent. The RBI’s own forecasts remain below 4 per cent.

Structural factors that kept inflation high are relieved. Food inflation will continue to remain moderate. Satellite data shows India has contributed to a rise in global greening because of multiple cropping. The political economy of the oil market has changed so much with more geographical dispersion, that even the disruptions in Saudi Arabia had only a temporary effect on prices. Household inflation expectations have anchored to lower rates, since in an emerging market with thin information, official announcements and forecasts have a large effect.

Commodity price inflation also affects expectations, but global inflation will remain low as growth contracts and exerts a moderating effect.

Constraints on transmission

There is a view that there should be no more cuts until there is full pass-through; but after the 2008 crisis, US experts had called on the Fed to compensate for high spreads. A pass-through happens through markets as well as banks. Such compensation is one reason larger cuts are required in financial markets with more frictions.

Moreover, financial sector constraints are mitigating in India. NPAs have peaked, and bank credit growth and pass-through is improving. The carrot of recap is being dangled with the stick of external benchmarks and credit-risk based loan push.

Most importantly, aggregate liquidity is in surplus, with adequate durable liquidity. Then banks’ costs fall and incentives to lend rise. However, in an environment where banks have to compete for deposits (credit growth has exceeded deposit growth in the past year) the pass-through to the deposit rate will be lower. Banks will have to compete for deposits even as fresh loans are linked to external benchmarks.

Sectoral liquidity constraints are also being eased. Banks are keener to lend now under the various packages announced. In the long term, complementary business partnerships between banks and NBFCs are likely to be most useful. The initiatives from the government to provide last-mile financing for the housing sector are also timely.

A stitch in time

There is an argument that high government borrowing will not let G-Secs and other market rates fall. But they did fall from around 8 per cent to 6 per cent under surplus liquidity and OMOs, before rising to 6.7 per cent after the corporate tax cuts were announced.

But these are unlikely to lead to a more than 0.5 per cent rise in the fiscal deficit. Retail interest in, and avenues for participation in G-Secs markets, is rising.

Although household net financial savings have fallen, corporate savings have risen. Corporate treasuries also hold G-Secs. The transfer from the RBI under the Jalan committee will allow the government to start spending without having to borrow. Asset sales are possible. Tax collections will improve with growth.

Although sentiments have improved, a rise in investment will take time. Demand-side policies, such as lower real interest rates, continue to be required. Some counter-cyclicality in deficits will help.

As international interest rates are falling, India’s interest rate differential is adequate. Fixed income flows get capital gains from softening rates, and growth is the main attraction for FPI.

A final argument is to wait and see the effect of past cuts. But if output gaps worsen, deeper cuts would be required. It is no use saving ammunition for the next war, when we’re in the middle of one. Under inflation targeting, the real rate cannot be kept above neutral in a slowdown.

The writer is Professor, IGIDR, and Member, EAC-PM

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