In what was perceived as a counter to critics who had attacked him for keeping interest rates high for long, RBI Governor Raghuram Rajan Monday said the Indian central bank was “wise to disregard advice in the past to cut more deeply”.
Delivering the Foundation Day lecture at the Tata Institute of Fundamental Research (TIFR), his first public engagement after announcing Saturday that he will not continue in office when his term ends on September 4, Rajan said inflation had come down to the upper band of the target zone and “we can never abandon inflation to focus on growth”.
“The RBI always sets the policy rate as low as it can, consistent with meeting its inflation objective. Indeed, the fact that inflation is fairly close to the upper bound of our target zone today suggests we have not been overly hawkish, and were wise to disregard advice in the past to cut more deeply,” he said.
Rajan also had some advice for his successor: “In the days ahead, a new Governor, as well as members of the committee (Monetary Policy Committee, which will decide rates) will be picked. I am sure they will internalise the frameworks and institutions that have been set up, and should produce a low inflation future for India.”
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Consumer price inflation was 5.76 per cent in May, or the upper end of the RBI’s inflation target of 2-6 per cent.
Defending his policies, Rajan said, “If a critic believes interest rates are excessively high, he either has to argue that the government-set inflation target should be higher than it is today, or that the RBI is excessively pessimistic about the path of future inflation. He cannot have it both ways — want lower inflation as well as lower policy rates.”
BJP MP Subramanian Swamy has in the past attacked Rajan for keeping interest rates high and wrecking the economy.
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“When people say ‘inflation is low, you can now turn to stimulating growth’, they really do not understand that these are two sides of the same coin,” Rajan said.
He said the best way for a central bank to ensure sustainable growth is to keep demand close to supply so that inflation remains moderate, and the other factors that drive growth, such as good governance, can take centrestage.
“We can never abandon inflation to focus on growth,” he said, but added that the best way the monetary authority can support growth over the medium term is to anchor inflation at low levels so that policy rates can also be low.
If industrialists, he said, want significantly lower rates, they have to support efforts to improve loan recovery so that banks and bond markets feel comfortable with low credit spreads.
“The central and state governments have to continue on the path of fiscal consolidation so that they borrow less and thus spend less on interest payments. Households will have to adjust to lower nominal rates, but must recognise that higher real rates make their savings more productive,” he said.
On complaints of businessmen regarding high rates, Rajan said, “High and variable inflation causes lenders to demand a higher fixed interest rate to compensate for the risk that inflation will move around (the so-called inflation risk premium), thus raising the cost of finance. The long-term nominal (and real) interest rates savers require rises, thus making some long-duration projects prohibitively costly.”
“So when someone berates us because heavily indebted industrialists borrow at 14 per cent interest with WPI at 0.5 per cent, they make two important errors in saying the real interest rate is 13.5 per cent. First, 7.5 per cent is the credit spread, and would not be significantly lower if we cut the policy rate (at 6.5 per cent today) by another 100 basis points,” he said.
Stating that high inflation hurt the poor, Rajan said, “We had gotten used to decades of moderate to high inflation, with industrialists and governments paying negative real interest rates and the burden of the hidden inflation tax falling on the middle class saver and the poor. What is happening today is truly revolutionary — we are abandoning the ways of the past that benefited the few at the expense of the many.”
India experienced an average of more than 9 per cent inflation between 2006 and 2013.
Explaining the rationale for selecting CPI as the basis for the RBI policy, Rajan said wholesale price index contains a lot of traded manufactured goods and commodity inputs in the basket, whose price is determined internationally.
“A low WPI could result from low international inflation, while domestic components of inflation such as education and healthcare services as well as retail margins and non-traded food are inflating merrily to push up CPI. By focusing on WPI, we could be deluded into thinking we control inflation, even though it stems largely from actions of central banks elsewhere. In doing so, we neglect CPI, which is what matters to our common man, and is more the consequence of domestic monetary policy,” he said.
On Britain’s exit from the European Union (Brexit), Rajan said it could be “quite damaging” if it happens, but India is adequately prepared to face any consequences. “We will do what it takes to moderate market volatility. I am not saying (there will be) no volatility, but once the initial bout or wave abates, people will look for good fundamentals,” he said, adding that there are various sets of preparations, starting with monitoring the markets and ensuring “we have good policies”.
He said the maturing of NRI deposits later this year, another key concern on the external front, is “not significantly worrisome” and added that there are “plenty of reserves” to deal with any situation. “The US elections are also fraught with potential risks,” he said.