Beyond the rate cut

RBI alone will not be able drive economic recovery

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is widely expected to cut the repo rate once again this week. Although the inflation rate based on the consumer price index inched up in June, it is unlikely to cross 4 per cent in the near term. However, the bigger question at this stage is: Will another rate cut be enough to revive economic activity?

The Indian economy is in the midst of a severe slowdown and indicators such as vehicle sales, corporate results, and the latest core sector data suggest that growth in the first quarter of the current fiscal year might have slipped below 5.8 per cent, registered in the January-March quarter. Further, there is absolutely no fiscal space to support growth. In fact, the data on tax collection indicates that meeting Budget targets will not be easy and may require expenditure compression. An adjustment to accommodate higher spending would not be advisable, because the combined public-sector borrowing is already on the higher side.

The Indian economy is also unlikely to get support from the rest of the world. The global economy is losing momentum. The US Federal Reserve reduced interest rates last week for the first time since the global financial crisis. The ongoing US-China trade war, uncertainty around Brexit, and geopolitical tension in West Asia are risks for global growth.

In the given economic backdrop, it is worth asking whether the monetary policy will need to do the heavy lifting in terms of reviving growth. In the June meeting of the rate-setting committee, Governor Shaktikanta Das had noted: “Keeping in view the evolving growth-inflation dynamics, there is a need for decisive monetary policy action.” The growth outlook has only worsened since then. Thus, aside from the rate cut this week, all stakeholders would look for cues for the extent to which the central bank is prepared to support growth. Since the primary objective of the RBI is to keep inflation around 4 per cent (midpoint of the target range), it would be important to see how the MPC expects inflation and growth to move in the coming quarters. If it expects growth to slow significantly, more space could open up for monetary easing. Prices are unlikely to go up sharply with a slowdown in economic activity, as is being reflected by the decline in the core inflation rate in recent months.

Further, the MPC would do well to articulate the level of real interest rate it intends to maintain, and in what circumstances it could be reduced. This will give confidence to the system that the central bank will not deviate from its inflation-targeting mandate and help anchor longer-term inflationary expectations. It is also important to not disincentivise and discourage financial savings. To ensure that the economy benefits from policy accommodation, the central bank would need to work on the transmission of rates. 

But monetary accommodation can work only up to a point and won’t be su­f­f­icient for a meaningful recovery. The government will have to play its part. So­me of the recent steps, such as a higher rate of income tax for the super-rich, hi­g­her import duty, additional powers to the bureaucracy, etc have significantly af­fected business confidence. Reassessing some of the recent decisions and the way the economy is being handled would be a good starting point for the government.