Economic basics suggest RBI’s 6.5% policy rate is apt
- A good look at the impact of monetary policy on credit and GDP growth would argue against easing. One need not be a monetarist to agree that price stability should remain the central bank’s priority.
Monetarism a la Friedman says that inflation everywhere is always a monetary phenomenon. Increasing money supply by lowering interest rates can bring about only short-term gains in terms of increased GDP. But as time passes, it will be inflationary, as price expectations and wages adjust to increased money supply.
On the other side, Keynesian economics advocates an administrative role in GDP expansion when an economy is operating at less than full capacity, with a fiscal and monetary push as the ideal way to support economic activity. Therefore, we have two opposite views on intervention, called the ‘fresh water’ and ‘salt water’ schools since the 1970s. Each school would run down the other, arguing that the other was only a special case of its own ‘true economics.’
The debate is relevant today to India, with a decision to be taken on monetary policy soon. With the inflation trajectory coming down of late, there is a view that the repo rate should be cut. The argument given is that if this is not done, economic growth will get affected. The counter-argument is that with India’s growth pegged at 7.6% in 2023-24, that linkage is weak. There might even be the risk of the economy getting over-heated if interest rates are cut at this stage. It can also be inflationary, diluting the effort put in so far to achieve price stability.
Rate-cut enthusiasts argue that what’s important is that the central bank’s repo rate at 6.5% is very high and out of sync. Further, core inflation (minus volatile food and fuel) is below 4%, and this is the component that is influenced by monetary policy.
How, then, is one to look at this debate?
Data on various aspects of the economy could throw some light on this issue. In the last 13 years starting from 2011-12, the repo rate has been above 6% in 10 years and at 4-4.4% in three years. The latter was the covid period, which was exceptional. Second, the average repo rate over this period was 6.30%. Third, as for the real repo rate, of the 12 years, it was negative for six years, above 1.5% in five years, and 1% in one year. These three observations show that today’s repo rate is not extraordinary, but ruling at the trend rate. There is clearly no need to hit the ‘haste’ button, unlike in the US, where the policy-rate range of above 5% is unusual.
We can look at the impact of monetary policy on the economy through two main variables. The first is credit, and second, GDP growth. India’s real repo rate displays four distinct phases over a 12-year period. In the first, 2012-13 and 2013-14 had a negative real repo rate. The second covers five years from 2014-15 to 2018-19, with a positive real repo rate average of 2.1%. The third phase spans four years, from 2019-20 to 2022-23, when we had a negative real repo rate. The last phase of a positive real repo rate is the current year of 2023-24.
Growth in credit has shown varying trends. In the first phase, growth was 14.1% followed by 10.3%, when real repo rate averaged 2.1%. The covid phase had growth of just 8.8%, when the real repo averaged -1%, while the current year has shown growth of 16% with a positive real repo rate of about 1%.
Clearly, a lower real repo rate does not lead to higher credit growth. Borrowing is a function of demand and a growing economy will see companies invest even if interest rates are high. Therefore, to conclude that high rates imperil credit growth is a weak argument. The current year is a classic case of interest rates peaking while growth in credit has been high, thanks to retail borrowers, a phenomenon that has prompted the bank regulator to rejig capital norms. Here too, it can be seen that people do not stop buying homes because rates are high, as purchase decisions are based on the price of the dwelling and ability to pay off a home loan. In a typical period of 15-20 years for repayment, floating rates of interest would move up or down at different points of time, and so the current rate matters little. This is also borne out by the fact that negative real repo rates during 2020-23 had weak growth in credit; demand was low in general and households were unsure of the future. Hence, there is reason to believe that there is no clear relation between the two variables and borrowing decisions are taken based on other factors.
The other variable is GDP growth. Here too, let us assume that repo rate changes see adequate transmission. In phase one, GDP growth averaged 5.9%. The second phase witnessed high average growth of 7.4% over five years. The 2020-23 period witnessed average growth of only 3.6%, while 2023-24 is expected to log 7.6%. Once again, it can be seen that relatively high repo or real repo rates did not get in the way of growth.
These two relationships show that the monetarist view has probably held firmer in our context when it comes to targeting growth. It may be recollected that before the monetary policy committee (MPC) concept came up, our credit policy always spoke of a balance between growth and inflation. However, the MPC was mandated to pin inflation down at 4%. Based on the arguments provided here, it does appear that we need to concentrate more on inflation right now. Moreover, growth has been on an upward trajectory and this expansion is unlikely to be stymied. All said, a repo-rate range of around 6-6.5% does not look out of place even if the real rate is 1.5-2%.
The philosopher Friedrich Nietzsche said there are no facts, only interpretations. This is not the end of this debate.
These are the author’s personal views.
