October 5, 2019 12:51:00 am
On Friday, the Monetary Policy Committee cut the benchmark repo rate by 25 basis points, as high frequency indicators point to continued weakness in economic activity. Since February this year, the MPC has cut interest rates by 135 bps. The central bank also lowered its growth forecast to 6.1 per cent, down from its previous estimate of 6.9 per cent, suggesting that the slowdown is more severe than was previously believed. It has also decided to stick to its accomodative stance till “as long as necessary to revive growth”, which signals further rate cuts if growth disappoints, especially as inflation is likely to remain well within its comfort zone.
That the MPC was going to cut rates was a foregone conclusion. The disagreement was over the quantum of the cut — one MPC member voted for a larger cut. A cut of this magnitude is at odds with the sharp downward revision in its growth forecast. That demand remains subdued, capacity utilisation has dropped, credit offtake remains sluggish, and capital goods imports continue to contract, raises the question: If the growth forecast was revised downwards to this extent, surely there is a case for a much larger rate cut? Uncertainty around the effects of the recent stimulus measures may have played a role. It is also possible that the MPC is waiting to see how banks adapt to the new external benchmarking system, and how effectively they transmit these rate cuts to the larger economy, before easing further. The RBI acknowledges that transmission has been a problem so far. While the repo rate was cut by 110 bps between February and August, the lending rate on fresh loans declined by only 29 bps. Part of the problem can be traced to the continuing high interest rate differential between bank deposits and small saving instruments. This exists because the rates announced by the government on small savings are higher than those arrived at by the formula which reflects market realities. This differential restricts banks’ ability to cut term deposit rates and, as a consequence, lending rates. As the efficacy of monetary policy depends on transmission, the government should align interest rates on small savings with market rates.
The combination of low growth and low inflation shifts the balance towards further easing. But what is the terminal rate? Going by the RBI’s commentary in the past, a neutral stance implies a real interest rate of around 1.25 to 1.5 per cent. But an accommodative stance could imply even lower interest rates, opening up space for more aggressive cuts than what are currently being priced in. On its part, the government should stick to the fiscal deficit target. A shortfall in revenue, unless compensated by deep expenditure cuts, translates to higher borrowings, which impedes transmission of these cuts. The government should pursue a more aggressive disinvestment programme to offset the expected shortfall in tax collections.
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