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Theinterestrateconundrum
ThetimehascometoreduceRBIreporatesbypercentagepointsratherthanbasispoints
DeepakNayyar
Interestratesareinthenews.Moststakeholderswantedareduction
largerthanwhatwasannouncedbytheReserveBankofIndia(RBI).
Thefinanceministersoughttostimulategrowth.Corporateshopedto
reviveinvestment.Householdswaitedforsmallermonthly
instalmentspayableontheirborrowing.Everyonewasdisappointed
withtheoutcome.Italsoshapedexpectations.Stockmarkets
tumbled.Thisisnosurprise.Interestratesareamongthemost
importantpricesignalsinamarketeconomythatdetermine
investmentdecisionsoffirmsandconsumptiondecisionsof
households.

BetweenMarch2010andOctober2011,RBIraisedtherepo
rate13times,from4.75%to8.5%perannum.Photo:
Bloomberg

Initsperiodicmonetarypolicyreview,theRBIannounceschangesin
thereporate,therateatwhichitlendstocommercialbanks,whichis
thebasicdeterminantofinterestratesintheeconomy.Itisa
referencerate,muchlikeUSprime(basedonthefederalfundsrate)
orLibor,sothatlendingorborrowingratessetbycommercialbanks
orfinancialinstitutionsuseitasabenchmarkforinterestratesthat
depend,interalia,onmaturityperiodsandriskprofiles.

BetweenMarch2010andOctober2011,RBIraisedthereporate13
times,from4.75%to8.5%perannum.Itwaschangedseventimesthereafter,upordown,untilJanuary2014,butremainedbroadlyinthe
rangeof8%perannum.Thedownturnintheeconomy,from201112to201314,witnessedasharpslowdowningrowth,asubstantialdrop
ininvestment,persistentdoubledigitinflationandmountingbalanceofpaymentsdeficits,leadingtomassiveerosioninconfidence.Raising
interestrates,timeaftertime,wasthepolicyresponseandthelastresortofthegovernment.Itdidalmostnothingtotameinflationorresolve
macroeconomicproblems.Andthepoliticaloutcomewasadrubbingforthegovernmentinthenationalelection.
TheNarendraModi governmentthatassumedofficeinMay2014inheritedadifficulteconomiclegacy.Yet,itsdecisivemandateshored
sentimentandrestoredconfidencetounleashexpectations.Alas,itsfirstUnionbudget,nomorethanaholdingoperation,didlittletorevive
growth.Butthegodswerekind.
Themonsoonturnedouttobebetterthanexpected.Andtherewasmoremannafromheaven.Worldpricesofcrudeoildroppedfromaround
$110perbarrelinendJune2014tolessthan$50perbarrelinendJanuary2015,toremainintherange$5560perbarrelsincethen.This
bonanzaof$50billionperannumcreatedfiscalspaceforthegovernmentandslashedthetradedeficitandcurrentaccountdeficitinthe
balanceofpayments.Aboveall,itdampenedinflation.BetweenApril2014andApril2105,theannualrateofinflationdroppedfrom6%to
2.7%intermsoftheWholesalePriceIndexandfrom8.4%to4.9%intermsoftheConsumerPriceIndex.
Thus,inthefirstyearoftheModigovernment,inflationdroppedby8.7percentagepoints(870basispoints)to3.5percentagepoints(350
basispoints)dependingonthemeasureused,largelybecauseofthecollapseinworldoilpricesanddecentsupplymanagementina
deficientmonsoonyear.Thisprovidedafantasticwindowofopportunitytodropinterestrates.TheRBIresponsewasfeeble.Itreducedthe
reporateby25basispointseachtimeinJanuary,MarchandJune2015.Itwassimplytoolittletoolate.Giventhatinflationdropped
anywherebetween3.5and8.7percentagepoints,whiletheRBIratedroppedbyamere0.75percentagepoints,realinterestrates,infact,
roseby3to8percentagepoints.Inthiscontext,wemustalsorememberthatlendingratesareatleast45percentagepointshigherthanthe
reporate.ThetimehascometoreduceRBIreporatesbypercentagepointsratherthanbasispoints.
Theslowdowningrowthduring2011/122013/14was,inlargepart,attributabletothedropininvestment,asgrossfixedcapitalformationfell
from33.6%to29.7%ofGDP(201112series),byalmost4percentagepoints.Thingsgotworsein201415,asthisproportionwas28.7%,
whichwasanother1percentagepointlowerthanin201314.Obviously,highinterestratescrowdedoutinvestment.Itisalmostimpossible
formanufacturingfirmstouseborrowedcapitalforfinancinginvestment,whenratesofreturnhavetobehigherthannominalinterestratesat
13%perannumandrealinterestratesmuchhigherthaninthepastasinflationhascomedown.Ifinvestmentcontinuestobestifled,
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possibilitiesofrevivinggrowthandcreatingemploymentareseriouslyconstrained.
ItwouldseemthatlittlehaschangedatRBI.Thepreviousgovernor,DuvvuriSubbarao,wasmuchcriticizedforhishawkishapproachto
interestrates.However,thepresentgovernor,RaghuramRajan,isevenmoreofaninflationwarrior,ashehasturnedadeafeartoevery
pleathathasurgedhimtolowerinterestrates.Theostensiblereasonisthatthewaragainstinflationisnotyetover.Clearly,evenfacts
cannotchangebeliefsystemsthatareembeddedinideology.Butitisimportanttorecognizethattheunderlyingmacroeconomicsisflawed.
Therearedebatesamongcompetingschoolsofthought.Yet,thetwoessentialquestionsarethesame:whatcausesinflationandwhat
shouldbedoneaboutit?Thebasicmonetaristview,bornandbroughtupinChicago,isthatexcessliquiditycausesinflationsothata
restrictivemonetarypolicyisthesolution.Insofarasgovernmentsarefallible,simplerulesarebest.Intheheydayofmonetarisminthe
1980s,themostfavouredruleprescribedexpandingmoneysupplyataconstantrate.Thisrulewasdiscreditedwhenitbecameclearthat
thedemandfunctionformoneywasunstableandunpredictableespeciallyindevelopingcountries.Inflationtargetingthenbecamethe
preferredrule.Inthis,thecentralbanksetsaninflationtargetforthemediumterm,whichismadepublic,andinterestratesareraisedor
loweredtostayontarget.Thisrulealsoturnedpass,astherewereseriousproblemsofcoordinationwithfiscalpolicyinmanagingexternal
balanceandincopingwithassetbubbles,whichbecameclearintheglobaleconomiccrisis.Strangelyenough,inIndia,thebeliefsurvives
toholdsway.
Theproblemliesnotonlyintheapproachbutinitsunderstanding.IfinflationinIndiawasbeingdrivenbyexcessliquidity,highinterestrates
andrepeatedhikesshouldhavedampenedinflation.ItdidnothappensinceinflationinIndiawasdrivenbysupplydemandimbalances,
whichwererealratherthanmonetaryfactors.Itwasthesharpdropinoilprices,combinedwithbettersupplymanagement,whichwas
responsiblefortaminginflation.Insuchcircumstances,restrictivemonetarypolicywasprobablycounterproductivebecauseitstifled
investment,dampenedgrowthand,ifitsqueezedsupplymorethandemand,inflationpersisted.
Indeed,itisplausibletoarguejusttheopposite.Lowerinterestrateswouldstimulateinvestmentandrevivegrowth,whileemployment
creationwouldstimulatedomesticdemandthatwould,inturn,drivegrowth.Butthatisnotall.Itiscreditmorethanmoneysupplythatmatters
forthelevelofeconomicactivity.Iffirmsandhouseholdsarecreditconstrained,loweringinterestratesmaymeanthatfirmswillhavemore
moneytoinvestandhouseholdswillhavemoremoneyforconsumption.Iflendershaveruleslimitinglendingtodebtservicingcapacity,
lowerinterestrateswouldleadtoanincreasedwillingnesstolendonthepartofcommercialbanks.Thismightcreateavirtuouscircleof
cumulativecausation.
Theallegedtradeoffbetweeninflationandgrowth,stressedbyorthodoxy,isafalsedilemma.Experienceacrosscountriesprovideslittleif
anyevidenceinsupport.Itisonlyveryhighinflationorhyperinflationthatisassociatedwithlowgrowthoreconomicrecession.Infact,
evidencedoesnotvalidatetheorthodoxviewthatlowinflationfacilitateseconomicgrowth.Onthecontrary,itshowsthatmoderateratesof
inflationhaveoftenbeenaccompaniedbyrapideconomicgrowth.Thefightagainstinflation,intheorthodoxmode,almostalwaysleadsto
higherunemployment.Itistruethatthelesswellofforthepoorbearthecostsofinflation,butitisjustasimportanttorecognizethatthecosts
offightinginflationinthemonetaristmodeareperhapsevengreaterforthelesswellofforthepoor,particularlytheunskilledandthe
unemployed.
Economicideasandideologiessettheagendaforactionandchange.Butwemustlearntoquestionandgetawayfromablindbeliefinany
idea,forideologiesthatturnintofaitharedangerous.Monetarypolicymightseemtrivialinthewidercontextofeconomy,polityandsociety.
Buteconomicoutcomes,whicharepathdependent,dohavepoliticalconsequencesatelectiontimeandsocialconsequencesinthewell
beingofpeople.Itwouldbebothprudentandwiseforthegovernmentnottoputallitseggsinonebasket.Instead,itshouldbeopen
mindedinconsideringdifferentviewsbeforemakingcriticaleconomicpolicydecisions.Insuchmatters,thereisalwaysaneedfor
institutionalchecksandbalancessothatneithertheReserveBankofIndianortheministryoffinancefunctioninanunfetteredunilateral
manner.Thisistooimportantamattertobelefttoeconomistsalone,letaloneonepersoninMintStreet.
DeepakNayyarisemeritusprofessorofeconomics,JawaharlalNehruUniversity,NewDelhi.Heservedasthechiefeconomicadvisor,
GovernmentofIndia,from1989to1991,andasvicechancellor,UniversityofDelhi,from2000to2005.

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