India needs opportunistic tightening

For all the widespread near-religious faith in lower interest rates, they are of dubious efficacy in inducing the investment of the right kind

Photo: Mint
Photo: Mint

It is often said that the urgent and the immediate are not the same as important. Indeed, they are in conflict with one another. All the urgent and the immediate commentary on the decision by the newly constituted monetary policy committee (MPC) of the Reserve Bank of India (RBI) has already come out. RBI has released the minutes of the MPC meeting too. The bulk of it has been seen earlier in the press release that followed the meeting.

Observations made by individual members of the MPC were newsworthy. Those who were in favour of the rate cut anchored their rate cut on the anchoring of inflation forecasts by professional forecasters. They chose to ignore the survey of inflation expectations that RBI conducts among citizens. That has a sample of over 5,000 people. It is in its 12th year. It is not clear if MPC members studied the track record of forecasts made by professional forecasters before choosing to assign it a greater weight in their decision. If they had done so, it is likely that they found it to be no superior to the forecasts or expectations generated by ordinary folks.

Inflation expectations among the public are based on their shopping experiences. It seems to be true not just of emerging economies but of developed countries too.

Readers should look up the paper presented in a Brookings conference last year on the (little or no) role of monetary policy in anchoring inflation expectations in New Zealand (Inflation Targeting Does Not Anchor Inflation Expectations: Evidence From Firms In New Zealand, September 2015).

In India, inflation expectations jumped sharply in the September survey of households on inflation expectations based on their experience with food prices in the summer months of May to July. In August, food prices drifted lower. But it remains to be seen if this trend will persist.

Evidently, the MPC thinks that it will persist at least for a quarter more. Credit Suisse seems to agree with them, pointing to food surpluses across all categories. This, in turn, is attributed to a decline in per capita calorie demand (is it a good thing?) and an improvement in agricultural productivity.

Therefore, they expect the public to be surprised by the extent and duration of the decline in inflation and consequently in interest rates (Interesting Times, Credit Suisse, 22 September 2016). One hopes that they are right.

One must keep in mind other non-conforming evidence, though. RBI members of the MPC correctly pointed to the sharp rise in input costs for Indian companies. To that concern, one must add the steady rise in staff costs per value of production in services and in manufacturing (Chart II.16b, “Monetary Policy Report”, Reserve Bank of India, October 2016). This is similar to the concept of unit labour cost and hence is indicative of labour productivity or the lack thereof.

As of the first quarter of the current financial year, in manufacturing, staff costs per value of production are rising at an annual rate of around 6.5% and in services, the rate is around 22%.

Therefore, one should not be surprised that the Indian corporate sector has kept its calls for lower interest rates and a competitive exchange rate on an auto-replay mode. These are the only instruments of international competition for the majority of them. Monetary policy and trade policy have to shoulder the costs of their failure or willingness or both to boost productivity. That is why any time is propitious for a rate cut in India.

The new MPC obliged. It was a marginal decision and most of the MPC members seem to be aware of it.

RBI reckons that India’s potential growth rate has come down and that the economy is growing at below potential.

A working paper published by RBI in April put the potential real growth rate of the economy at below 7%. That calls into question its own forecasts of the growth rate of Gross Value Added this year and next and that of the consensus.

Unfortunately, interest rate cuts won’t solve this problem much as it appears theoretically reasonable to believe so. For all the widespread near-religious faith in lower interest rates, they are of dubious efficacy in inducing the investment of the right kind. They do boost investments of the wrong kind (for example, in real estate) but that will do nothing to change India’s recent experience of short-lived growth spurts.

Therefore, one hopes that the MPC resists the temptation to cut rates opportunistically, in future. Indeed, given India’s chronic current account deficit, stagnant savings rate and poor capital formation, there is a stronger case for opportunistically tight monetary policy.

Indeed, RBI’s October monetary policy report struck the right note in its conclusion to Chapter III. It acknowledged that the economy was growing below potential and that aggregate demand was essentially consumption-driven. It identified correctly the risk posed by the continuing weakness in capital formation for potential output. It noted that productivity was impaired. It called for reforms in product and factor supplies that would raise the economy’s potential.

In other words, it is not about lower interest rates.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.

Comments are welcome at Read Anantha’s previous Mint columns at

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