Earlier
this month all eyes were on Reserve Bank Governor Duvvuri
Subbarao. Every statement of his was read as signalling
whether he would raise interest rates and by how much
he would do so this time. With the economy having bounced
back and GDP growth approaching previous peaks, the
presumption was that the focus of the governor’s attention
would be the persistent and unacceptably high inflation.
He would, therefore, be willing to sacrifice investment
and growth, the pundits argued, by raising interest
rates so as to moderate inflation.
There is no single interest rate in any economy. To
raise interest rates, the central bank has to select
and change a particular rate, which, in turn, is expected
to move other rates in the same direction. For some
time now the relevant rate in India has been the repo
rate or the rate at which banks borrow money from the
Reserve Bank of India (RBI). An increase in the repo
rate by increasing the cost at which banks can access
short-term capital is expected to induce them into raising
their lending rates and the rates they pay the depositors
from whom they mobilise much of their capital. Besides
this, a change in the interest rate would affect variables
such as the prices of assets (stocks and housing) and
the exchange rate. But the main channel through which
interest rate adjustments are expected to work their
way through the economy to reduce inflation is through
the impact that the policy rate has on various commercial
interest rates, such as those for mortgages, for consumer
loans, as well as for deposits.
In its most recent monetary policy statement, the RBI
has met analyst expectations by raising the repo rate
by half a percentage point (or 50 basis points) from
6.75 to 7.25 per cent. It has not opted for any other
measures such as attempting to pre-empt lendable resources
by raising the cash reserve requirement (CRR) imposed
on banks. The central bank is clear about the intent
of its manoeuvre. Its statement issued on May 3 notes:
“Over the long run, high inflation is inimical to sustained
growth as it harms investment by creating uncertainty.
Current elevated rates of inflation pose significant
risks to future growth. Bringing them down, therefore,
even at the cost of some growth in the short-run, should
take precedence.”
To those not familiar with the discourse on economic
policy, this move must have been surprising for just
one reason. Over recent months, the Governor has more
than once raised interest rates in order to rein in
inflation. Yet inflation, especially food price inflation,
has been stubbornly high, even if moderating in recent
months. Clearly, monetary policy in the form of a hike
in the interest rate has not been an effective weapon
against inflation.
According to its advocates, a hike in interest rates
is expected to have a number of effects, including a
fall in investment because of the higher cost of capital,
a rise in saving because of more attractive returns,
and a reduction in credit-financed consumption because
of the rise in the cost of credit. The resulting contraction
in demand (and growth) is what is expected to moderate
inflation. The argument is premised on the grounds that
the central bank can influence the relevant interest
rates with its policies and that high inflation is the
result of an excess of expenditure relative to supply,
determined by the volume of available output and imports,
which a hike in interest rates could correct. To the
extent that these premises are not valid, monetary policies
in general and interest rate changes in particular will
fail to have any impact on the rate of inflation.
There are three reasons why they could be wrong. The
first is that the presumed transmission of the effects
of changes in the repo rate to other commercial rates
that matter may not occur. The RBI has in the past been
concerned that there is inadequate transmission of the
effects of interest rate policy, though it feels that
matters have improved considerably recently.
The second is that even if the rate hike is more-or-less
generalised, its impact on investment, savings and consumption
may be too weak to make a difference. However, in recent
years the belief has been that even if the impact of
an interest rate hike on productive investment is limited,
it would substantially squeeze credit-financed investment
in housing, and credit-financed purchases of automobiles,
durables and commodities, dampening demand and growth,
with attendant effects on prices.
The third reason is that price increases may not be
the result of demand-supply imbalances caused by excess
expenditures relative to available supplies. This does
seem substantially true in India, especially with respect
to food. It cannot be denied that the long-run neglect
of the food economy in India has slowed production increases
and provided the basis for supply-demand imbalances
when growth recovers or accelerates. But two factors
have limited such potential imbalances. To start with,
when GDP growth occurs, its benefits tend to be unequally
distributed, with households whose consumption basket
is dominated by food items being the selective victims
of budgetary cuts. Further, in recent years India has
had ample reserves of foreign exchange to import commodities
in short supply and correct supply-demand imbalances.
If the economy has still been experiencing inflation,
it seems to be the result of two other factors. One
is that domestic prices are increasingly tied to global
prices partly because of the liberalisation of trade
and partly because administered prices are increasingly
calibrated to correspond to international prices. This
link between domestic and international prices has meant
that the rise in the prices of fuel, food and intermediate
prices in international markets has been transmitted
to India as well, with the government doing little to
restrain this “imported” inflation. As the RBI’s Third
Quarter Review of Macroeconomic and Monetary Developments
notes: “High global crude oil and other commodity prices
pose the biggest risk to India’s growth and inflation.
Persistently high inflation has kept inflation expectations
elevated. Fresh pressures from commodity prices do make
2011-12 a challenging year for inflation management.”
If inflation is influenced by global developments, adjusting
domestic interest rates may do little to redress the
problem.
The second reason for persisting inflation is that the
liberalisation of domestic trade, a reduced emphasis
on public distribution and the freedom given to traders
in commodities and futures markets, have encouraged
speculation and induced an element of upward buoyancy
in prices. It is indeed true that a hike in interest
rates, by increasing interest costs on borrowing to
finance speculation, could help dampen speculation.
But if the hike in interest rates is small relative
to the returns expected from speculation this may be
an inadequate disincentive.
Factors like these could explain not just the persistence
of inflation, but also the failure of past attempts
to hike interest rates to rein in inflation. If inflation
is imported and has little to do with immediate demand-supply
imbalance, contracting demand would not help. What the
hike in interest rates would do is increase the repayment
burden on loans taken to finance household investment
and consumption, especially investment in housing. The
evidence shows that personal loans that were an important
driver of growth before the financial crisis of 2008
have seen a revival recently. Aggregate personal loans
provided by the commercial banking sector rose by 17
per cent in 2010-11, as compared with 4.1 per cent in
2009-10. Within this category, the growth during 2010-11
in housing loans stood at 15 per cent and in loans against
consumer durables at 22.4 per cent, as compared with
7.7 and 1.3 per cent respectively in 2009-10. Those
taking on these loans would have in recent months been
faced with significant increases in the equated monthly
instalments they pay. This would not only discourage
further borrowing and new borrowers, but can lead to
defaults. Given the relatively high shares of personal
loans in the aggregate advances by banks, it could discourage
lending as well. So a contraction of demand and growth
is a real possibility.
Thus, while the RBI’s interest rate manoeuvre may end
up being successful in contracting demand and growth,
it is likely to fail to rein in inflation. If that transpires
it would be the result of using not just an inadequate
but a wrong instrument to address the problem at hand.
This
article was originally published in Frontline, 21 May,
2011.
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