How should the Narendra Modi government react to the ongoing economic slowdown?

Real economic growth is down to its lowest level in 25 quarters, while nominal economic growth is perhaps at a 15-year low. The sharp loss of economic momentum in recent quarters is a result of a shock to aggregate demand rather than the usual constraints on the supply side. The strongest indication of an aggregate demand shock is that inflation has been below target for several months now. It was running close to double digits during the comparable slowdown in 2013.

Most economists believe there is scope for the Reserve Bank of India (RBI) to cut interest rates to boost domestic demand. The space for fiscal action is relatively small, since total government borrowing is already soaking up most of the financial savings of households. How low can interest rates go?

An episode from recent Indian economic history is useful in offering some background. Bimal Jalan took charge of Indian monetary policy in November 1997. The previous RBI governor, C. Rangarajan, had applied the monetary brakes in a bid to stop inflation going out of control in the mid-1990s. Jalan had to tighten policy in early 1998 to defend the rupee in the aftermath of the Asian financial crisis.

However, Jalan began reducing interest rates as the inflation threat receded. An important turning point was the budget presented by Yashwant Sinha in February 1999. It promised a primary surplus, a signal that fiscal policy would be disciplined. The fiscal strategy of the Atal Bihari Vajpayee government gave the Indian central bank confidence to bring down interest rates as price pressures eased.

The parallels with the current situation are striking. An initial period of tight monetary policy to combat high inflation. Then an opportunity to bring down interest rates as inflation recedes. And, the importance of a credible fiscal policy to make it easier to loosen monetary policy. Each of these elements can be seen right now as well.

Here is a quick snapshot of the numbers. Average consumer price inflation dropped from 13.13% in 1998 to 3.82% in 2004. The current disinflation cycle saw consumer price inflation come down from 10.1% in 2012 to 3.48% in 2018. The disinflation trajectories have been broadly similar—a drop of 9.31 percentage points in the first instance (1998-2004) and 6.62 percentage points in the second instance (2012-2018).

However, the trajectory of interest rates has not been similar over these two episodes. The data here is for the weighted average of central government borrowing across the interest rate cycle. The average cost of government borrowing fell from 13.75% in fiscal year 1995-96 to 5.71% in fiscal year 2003-04. It has fallen more modestly in recent years from 8.52% in fiscal year 2011-12 to 6.97% in fiscal year 2017-18. (Official RBI data on fiscal year 2018-19 is not yet available.)

The upshot: The fall in inflation over the two cycles was broadly similar, but the fall in interest rates was totally different. Why? The reasons could be anything from the trend in domestic savings to the fiscal operations of the government to the importance given to inflation by the central bank.

However, let us focus on the third element for now. The theoretical edifice of inflation-targeting includes a central bank loss function. It shows how a monetary authority minimizes deviations from the inflation target on the one hand, and potential growth on the other. A popular application of this is the famous Taylor Rule. What does it tell us about Indian interest rates right now?

The Taylor Rule is sensitive to a bagful of assumptions—about the neutral interest rate, potential economic growth, optimum inflation and the relative weight given by the central bank to inflation versus growth. All these variables are not directly observed, which ensures that the Taylor Rule is a broad guide rather than a precise policy tool. The neutral interest rate is the rate at which an economy is on an even keel, neither overheating nor operating below potential.

Assuming that Indian economic growth right now is one percentage point below potential, inflation is half a percentage point below target and RBI gives equal weight to inflation, as well as growth, then a simple application of the Taylor Rule suggests that the repo rate should be at 4% when the neutral interest rate considered is 1.25%. However, the neutral interest rate itself is sensitive to the business cycle. Low levels of neutral interest rates—at 0.75% and 0.25%— put the repo rate at 3.5% and 3%, respectively.

The Taylor Rule is not a magic wand that can reveal the desired repo rate at any point in time. Monetary policy is a far more complicated business. But the Taylor Rule does suggest that there is still ample space to cut policy interest rates from their current level of 5.4%—or even more, depending on the neutral rate used in the calculation.

One final point: The Indian central bank has indicated that 1.25% is the neutral interest rate that it is comfortable with. Maybe it should tell us if that key number has been reworked in the downturn.

Sharmadha Srinivasan of IDFC Institute contributed to this article

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

Close