The inexplicable RBI rate cut

It is more than a week (or, exactly a week?) since the Reserve Bank of India, with its new monetary policy committee, cut interest rates by 25 basis points to 6.25%. It was a unanimous decision. I was surprised. The new committee could have taken its time. Establishing credibility of policy independence should have taken precedence over pleasing the government. The latter is how many would have interpreted the decision. Establishing credibility would provide greater leeway to ‘please’ the government later.

The press release put out by RBI actually made the case for a rate hike and not rate cut! I did not want to comment on the rate decision but the call by Indian corporate sector to boost consumption alarmed me enough to do this post. I had done a post on that here. RBI rate decision plays into this wrong call by Assocham, in this instance.

These are the important observations in the central bank’s post-meeting statement:

On the ‘real activity’ front

On the domestic front, the outlook for agricultural activity has brightened considerably. The south west monsoon ended the season with a cumulative deficit of only 3 per cent below the long period average, with 85 per cent of the country’s geographical area having received normal to excess precipitation. Kharif sowing has surpassed last year’s acreage, barring cotton, sugarcane and jute and mesta.

Nonetheless, business expectations polled in the Reserve Bank’s industrial outlook survey and by other agencies remain expansionary in Q2 and Q3.

The strong public investment in roads, railways and inland waterways, the recent efforts to unclog cash flows in large projects under arbitration, and the boost to spending from the 7th Pay Commission’s award, should improve the industrial outlook.

In the services sector, the acceleration in the pace of activity in Q1 appears to have been sustained.

An increasing number of high frequency indicators are moving into positive territory, construction is boosted by policy initiatives, and public administration, defence and other services will be supported by the pay commission award.

The momentum of growth is expected to quicken with a normal monsoon raising agricultural growth and rural demand, as well as by the stimulus to the urban consumption spending from the pay commission’s award. [Link]

On the inflation front

Inflation excluding food and fuel (including petrol and diesel embedded in transportation) has been sticky around 5 per cent, mainly in respect to education, medical and personal care services. Households reacted to the recent hardening of food inflation adaptively and raised their inflation expectations in the September 2016 round of the Reserve Bank’s inflation expectations survey of households.[Link]

Taken together, they made the case for a rate hike and not a rate cut!

Rajeev Malik has called out the central bank, without mincing words, here:

I personally can’t recall a rate cut by any credible MPC while indicating an upside risk to its short-term inflation forecast. The issue here isn’t the accuracy of the inflation forecast but the internal consistency of the action on interest rates and the inflation outlook. [Link]

Rajeev also added a pertinent comment on the real rate of interest:

the appropriate level of real interest rates (distinct from but confused with neutral rates) is not cast in stone, but the sudden change in the thought process is significant. Neither the weakness in global growth nor the downward shift in neutral interest rates globally is anything new—it isn’t clear what prompted RBI to signal this shift now and that too in the manner in which it was communicated.

Frankly, I was rather surprised by the comment made by Mr. Michael Patra in the press conference on the real rate of interest. He said that India’ real rate of interest had come down because globally real rates have come down! For the life of me, I cannot see a connection. India’s real rate is dictated by India’s real growth, savings and investment dynamics. This is what he said:

So, the neutral rate as you know, and as we have put out a research on this, is the time varying concept, does not stay still at a point in time and changes with things like demographics or the potential output itself. And the world over the sense is that the neutral rate is going down and that is why you see many countries actually putting in place negative interest rates, that is where they see their neutral rates. So, as far as we are concerned, in continuation of what has been articulated before, if you look at the risk free rate, that is the treasury bill rate, it is 6.5% and if you look at inflation expectation which is best exemplified in the RBI’s own projections of 5 per  cent, so you have a 1.5 per cent. But as I said, we need to take into account the global situation where the neutral rates are actually declining, so it could be around 1.25 per cent or thereabouts. [Link]

In response to another question, he added:

No, I mentioned 2016 – 2017 and that Q4 projection is 5 per cent. So, if you deduct 5 per cent from 6.5 per cent which is the risk free rate today, you are getting 1.5 per cent. But as I said, globally there is a tendency of the real neutral rate to go down overtime and that is where it is today. So, I would discount 1.5 per cent by 25 basis points and say that 1.25 per cent is the real neutral.[Link]

It is not my case that Mr. Patra does not know his economics. That would expose my stupidity. But, what troubles me is the conjecture to the question of what prompted him to make such convoluted justification for the rate cut. That does not augur well.

Ms. Usha Thorat, former Deputy Governor of the Reserve Bank of India, was not pleased with what she saw in the MPC decision:

Clearly, therefore, the most important takeaway of this policy from the new MPC and the new governor is that there seems to be a change in stance regarding the neutral policy rate.

The justification given in the press interaction, comparing our rate with advanced countries and not with China or Mexico is one-sided.

This change in stance — if interpreted correctly — does not augur well for savers and pensioners.

To sum up, the MPC has taken the opportunity to make everyone happy — except the silent bank depositor. Its credibility will depend on its stance when risks to inflation are increasing and it is hoped the academics will rise to the occasion when that happens. [Link]






One thought on “The inexplicable RBI rate cut

  1. Perhaps Michael Patra was referring to the Wicksellian neutral rate of interest (also called natural,I just looked it up), and was trying to say that if India’s rate was higher compared to the global neutral rate than that, through the currency appreciation channel, would feed into negatively affecting manufacturing/services sectors’ output.

    Though, overall, agree this seems to be ill-thought out (esp Ms. Thorat’s point about comparing natural rates with developing countries instead of developed ones). And completely not in keeping with the independence demonstrated by RBI in the Rajan era…


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