On August 7, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) announced a cut of 35 basis points in the repo rate, which is the rate at which the RBI lends to the banking system. On August 21 (that is, 14 days since the decision), as is the norm, the RBI released the minutes of the MPC’s deliberations. The importance of the minutes lie in the details they provide about how different MPC members view the state of the Indian economy, and what they believe is the key area of concern.
The MPC is made up of six members — three nominated by the Union government (Chetan Ghate, professor at the Indian Statistical Institute, Pami Dua, Director of Delhi School of Economics, and Ravindra Dholakia, former professor at IIM-Ahmedabad), and three representing the RBI (Governor Shaktikanta Das, B P Kanungo, and Michael Patra). The MPC meets every two months to review the monetary policy stance of the RBI.
Benign inflation trajectory
The MPC is mandated by law to ensure that retail inflation stays within a band of two percentage points of the target inflation rate of 4%. Since inflation has been well below the 4% mark, the MPC members have found it logical to repeatedly vote for rate cuts since February. This time was no different, and every member found enough policy space to cut the repo rate, even though two members (Dua and Ghate) voted for smaller cuts (25 bps) and one member (Dholakia) wanted a 40 bps cut.
With inflation worries out of the way for the time being, all members focussed on economic growth concerns. They quoted extensively from a whole bunch of RBI surveys that suggest that growth is under pressure. As chart 1 shows, professional forecasters project GDP growth to be less than 7% this financial year. The chances of touching 8% — either in the current fiscal or in the next — are almost non-existent. Similarly, as chart 2 shows, consumer confidence has worsened; even where it is positive, it is less so since the last survey. Chart 3 shows a similar story for business sentiment. Chart 4 shows how inventory-to-sales ratios are on their way up, thanks to the dip in sales.
Investment vs Consumption
Overall GDP can be boosted by one of four drivers: private consumption, private business investment, government expenditure, and exports. With government finances at their limit and exports lagging because of low global demand and trade tensions, the toss-up was between encouraging businesses to invest more, and incentivising individuals to consume more.
A rate cut does both but the minutes reveal MPC members differed on why they wanted a rate cut. In turn, this showed what they thought was the real problem in the economy that needed to be addressed.
For instance, Dholakia focussed on boosting the private sector’s investment in the economy by reducing real interest rates. “It is well recognized… that investment is a primary driver for economic growth and employment creation. In order to boost investment activities, positive sentiments and business-conducive environment need to be enhanced. It requires carrying out several economic reform measures in the land and labour markets, tariffs of electricity and other resources, and taxation of income and goods and services, besides urgently correcting prevailing high real interest rates in India. While most of these measures are not within the purview of the monetary policy, correction of high real interest rates to a certain extent is”.
In contrast, Patra and Kanungo were more concerned about the sharp fall in private consumption demand. “What is worrisome though is that other components of aggregate demand could be joining investment in the loss of speed. Private consumption, the bedrock of domestic demand (57 per cent of GDP), is losing momentum in both urban and rural areas… The overarching goal is to reinvigorate domestic demand and the time to do it is now,” stated Patra.
Explained | Why RBI’s monetary policy matters
The MPC has cut the repo rate by 110 bps since February but only about 40 bps have been transmitted to borrowers. Poor monetary transmission has consistently undermined the effectiveness of the MPC’s decisions. Banks don’t pass on the full cut because their cost of funds depends largely on the interest they pay on the deposits — both short and long term ones — that they accept. Unless those deposit rates also change, banks’ cost of funds will continue to stay high; this is why they are unable to pass on the benefit. An SBI analysis claims that if deposit rates were to come down by 100 bps, lending rates could fall by 40-50 bps.
That is why, even though all MPC members voted for a cut, some also cautioned about the limits to such cuts. “It should also be highlighted that there has been inadequate monetary transmission given the quantum of past rate cuts… By a large cut (35 bps) I feel we will be burning through monetary policy space without much to show for it. While the real economy needs some support, we should wait for more transmission to happen,” stated Ghate. Similarly, Patra stated: “Monetary policy has been proactive and front-loaded as the first line of defence. From here on, the space for monetary policy action has to be calibrated to the evolving situation, especially as the nature and depth of the slowdown is still unravelling and elbow room may be needed if it deepens.”
Implication of linking lending and deposit rates to repo rate
As mentioned earlier, banks can’t be expected to “only” link their lending rates (the interest rate they ask from borrowers) to repo without linking their deposit rates (the interest rate they pay to depositers) to repo as well. If they were to link both lending and deposit rates to repo, as SBI has done to some extent since May 1, it can improve monetary transmission. But there is a flip side — if this is done industry-wide, borrowers will rejoice every time the repo falls (since their EMIs will fall); however, savers such as the elderly will be unhappy (since their money will earn lower returns).