By Parush Arora
The Monetary Policy Committee (MPC) headed by Urjit Patel ended its intense two-day meeting on Wednesday. They maintained a neutral stance on repo rates (the rate at which the central bank lends to commercial banks) despite the government building pressure to be more accommodative. Except for Dr Ravindra H Dholakia, the six-person committee was in favour of keeping the repo rates at the current level of 6.25%. Though the relaxation in inflation and plunge in the growth rate have provided ample room for a rate cut, most analysts expected the neutral stance to prevail.
More on the meeting
The Statutory liquidity ratio (SLR) saw a reduction of 50 basis points down to 20% starting June 24th. The SLR is the ratio that banks must keep aside as a reserve in terms of gold and government approved securities before providing a loan to customers. The reduction in SLR will help banks become more liquid. Hence, more lending will be possible. The provisions required to be set aside for the home loan are also being reduced from Rs 400 per lakh to Rs 250 per lakh. The reduction in the amount the bank has to keep aside also means low home loan interest rates. The move was directed to provide a cushion to the real estate sector, which has been dispirited for quite a long time. The committee is also dedicated to working with the government in confronting the bad loans problem (NPAs).
Explaining the government’s motives
The government pushed hard for a more accommodative stance than the Monetary Policy Committee took. After the demand shock of November 2016 caused by the reduction in money supply through banning of high denomination currencies, the output growth rate has been tumbling. It dropped first from 8% to 7.1% for the fiscal year 2016-17, and now to a new low of 6.1% for the quarter which ended March 31st, 2017. At the same time, inflation is experiencing a similar downward trend because of the government’s robust policies to curb a rise in food prices.
The Consumer Price Index (CPI) plummeted to 2.99% in April 2017 compared to 5.47% last year. On the one hand, a good monsoon season contributed towards successfully tackling food inflation. On the other, demonetisation ensured a low price level for manufactured goods. Given the state of the economy, the demand of the government is justified.
Why the government’s suggestion went ignored
The fall in output was triggered by a short-term demand shock rather than a long-term degradation in productivity or technology. The economy will get back to equilibrium as soon as the process of remonetising ends—which is expected to happen very soon. Policy decisions have a lag effect, and their impact can be witnessed on the economy after 4-8 quarters. Though inflation is currently well under control, the ensuing months bring with them greater uncertainty and inflationary pressure.
The most important objective of an independent inflation targeting central bank is to keep inflation expectations aligned with the target. Expectations—though decreased from the initial 13%—are still quite high, riding at 9.3%. An accommodative stance might exacerbate the expectations, or delay the process of expectations getting aligned with the target. The Reserve Bank of India (RBI) also believed that a fall in the interest rate would not help the economy revive faster unless accompanied by a concrete fiscal stimulus. Instead, they are willing to contribute in the output recovery task through easing the credit flow mechanism into the economy.
The roll-out of the Goods and Services Tax (GST) on July 1st will have relocating effects which are expected to increase the inflation next quarter. Empirical evidence suggests that inflation increased in Australia, Canada, Japan, Malaysia, and Singapore after the implementation of a GST. The House Rent Allowance (HRA) increase for central and state government allowance is still pending. In the global market, the US and the European Union are thinking of shrinking their balance sheets, which they accumulated post-recession through quantitative easing. Now, the process back home will lead to rising interest rates. This could lead to capital outflows from the emerging markets.
Lowering interest rates now does not seem to be a good idea in the lights of all the ambiguity prevailing in the domestic and global environments. Though India has a sufficient cushion from the foreign threats along with the strong fundamentals, it seems acceptable in this environment for the RBI to hold its ground. In truth, only time will tell.
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