The reaction of global markets to the US Federal Reserve’s monetary stance suggests investors are vesting too much faith in easy money to promote investment and growth. That may be a mistake, one that could get compounded if Indian policymakers take a cue from it and lay excessive emphasis on the central bank’s policy rate of interest as a solution to the economic problems the country faces. Indeed, the Reserve Bank of India (RBI) does have more leeway to reduce its repurchase (repo) rate, now that the Fed has lowered its own lending rate in the US by a quarter percentage point—its first cut since the financial crisis of 2008-09. The move was along expected lines and would have passed without causing much flutter had the Fed chairman, Jerome Powell, not spoilt the mood among investors by calling the cut a “mid- cycle adjustment"—in other words, a one-off. That was enough to spook equity markets around the world, which had been pencilling in an entire season of easing. Their presumption is that more cuts are essential to keep the wheels of the global economy spinning. In this, they seem resistant to evidence that the efficacy of monetary policy is diminishing. In the West, this is largely because the cost of capital is already very low by historical standards. Plus, much cheap credit goes into chasing higher-paying assets around the world instead of spurring business activity. In India, monetary policy is even less potent in spurring investment. Various other factors beyond the cost of capital act as a drag.
The release of data—on car sales and core sector output—confirming a downslide in the economy clearly had a role in the bearish turn that equity markets took last week. Perhaps an RBI rate cut will stem the slide in stock prices, but this can be rationalized only by virtue of the signal it sends of the central bank’s intent to aid a sluggish economy, not for a quick revival it might bring about. Of the three- quarters of a percentage point reduction in RBI’s repo rate this year, banks have passed on barely half. Also, with consumption on a downtrend, the will of companies to borrow and invest is weak. What might restore market sentiment, instead, are renewed inflows from abroad into Indian shares and securities set off by the Fed’s move. However, if this happens, and it’s unclear if it will, RBI will be faced with a Hobson’s choice of letting either the rupee or yields rise in the country’s currency and bond markets, respectively.
If monetary easing by RBI does not help much and foreign inflows are uncertain, what should Indian policymakers do? Considering that the fiscal space available is tight, a rescue mounted on the back of an infrastructure spending spree might not suffice. What’s needed is a set of major reforms, the kind that allow market forces to play an effective role in arenas from which they have been barred all these decades. Easing land acquisition rules and turning the country’s labour market flexible could have a dramatic effect on India’s appeal as an investment destination. A reversal of some income tax rules seen as extortionary by rich investors would also help. Further, the long-term capital gains tax could be given a rethink. With the Narendra Modi government’s large political mandate, now is a good time for it to bite the bullet on reforms that weaker regimes dared not implement. Let’s not over-rely on monetary policy.