The six-member Monetary Policy Committee (MPC) headed by RBI governor Urjit Patel decided to lower the policy repo rate by 25 basis points to 6% on Wednesday. In the previous meeting of the MPC in June, the policy rate was left unchanged at 6.25%. The central bank considered a change in its policy stance “opportune” considering the downtrend in consumer inflation, normal monsoon, lower oil prices and smooth roll-out of the Goods and Services Tax (GST).
The big question is whether lower rates would revive flagging investments to boost industrial growth. Also, could the policy rate have instead been cut more aggressively, by say, 50 basis points to revive investment demand? The RBI doesn’t think so as it is hawkish on maintaining price stability.
The good news on inflation might not last for long and it is expected to creep up by the end of 2017-18. Much lower rates are possible only if inflation is tamed. And that’s a big if.
The RBI also expects the government, both at the Centre and state, to do its bit by controlling its finances so that rates come down. It is worried that the present clamour for farm loan waivers by state governments impairs fiscal discipline, crowds out investible resources and keeps interest rates relatively high.
Why is the RBI obsessed with inflation? Does it have the mandate to target only a particular rate of inflation? Not at all, as central banks all over the world have the flexibility to respond to various problems in the economy as and when they arise.
So, if India’s industrial growth outlook remains weak – which is the case at the moment – the RBI does have the mandate to boost economic expansion without worsening inflation. The central bank, however, remains fixated on inflation as it believes that even now there are upside risks for inflation than downside risks for growth. The current downtrend in inflation is expected to rise to 4% by Q4 2017-18.
By contrast, the finance ministry prefers the RBI to cut rates more aggressively to kick-start investments and boost industrial growth.
Although GDP growth is expected to be a robust 7.3% this fiscal, a major concern is that it is not investment-driven. The official indices that measure industrial production and core sector production do not show any buoyancy. Lower rates are expected to lower the cost of capital and rekindle the so-called animal spirits of entrepreneurs to invest more. It is not just the NDA but also the UPA government indicated in loud and clear terms that it expected much lower rates from the RBI. But the latter resisted these pressures.
That being said, lower rates are not a panacea for reviving investments. The RBI may lower them but the various banks are in no position to transmit these rates as they are burdened by huge non-performing loan portfolios. Only when their stressed balance sheets are cleaned up, can they lower their lending rates to stimulate more capital expenditures by corporates and reverse the slump in industrial production.