Updated: August 28, 2015 12:00:05 am
The Chinese central bank’s move to cut its benchmark interest rates and lowering of reserve requirements for banks — on top of devaluing the yuan against the dollar — raises further doubts about the sustainability of the Reserve Bank of India’s (RBI’s) hawkish monetary policy stance. The adoption of inflation targeting and its benchmarking to the consumer price index has, no doubt, lent credibility to the RBI as an institution, especially under the leadership of Raghuram Rajan. But this emphasis on inflation control even at the expense of growth is probably misplaced in the current global environment, where the dominant concern is over deflationary pressures. This is reflected in the actions of not just the People’s Bank of China, but even the central banks of other countries, including South Korea and New Zealand, which have lowered rates in response to growth tapering off amid shrinking global demand and crashing commodity prices.
The RBI seems to be the odd one out among central banks (barring maybe the US Federal Reserve, though even the Fed is now having second thoughts on raising interest rates). On Monday, the day of the bloodbath in the markets, Rajan spoke on why the central bank cannot be a cheerleader for the economy. The clamour for interest rate cuts from a besieged industry does not appear to have moved him. Essentially, the point he was making was that unless the central bank is certain that inflation will stay low for a sustained period, it won’t be pushed into easing rates, whatever be the pressures. Rajan further held that inflation expectations among the public are still high — leading to a gap between what savers expect in terms of returns adjusted for inflation and the rates that corporations think they ought to be paying.
Rajan is more of a monetarist in the mould of former governor C. Rangarajan, who took to the sledgehammer in the late 1990s to control inflation that had risen to double digits. It took over five years for the economy to recover. It is true that the growth that followed from around 2003-04 was healthy, as it was accompanied by low inflation, which was a result of the earlier monetary tightening under Rangarajan. Going by that logic, Rajan has every reason to persist with the current hawkish approach until inflation is truly stabilised at low single digits for a reasonably long period of time. But this
argument ignores a fundamental difference between the early 2000s and now. The GDP growth recovery that happened from 2003-04 coincided with the start of a global economic boom. Today, the world economy has entered a phase of deflation that could well be prolonged. The stimulus for growth, therefore, has to come from within, and not outside the economy. That being the case, there is no real alternative to slashing interest rates.
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