Does the RBI's monetary policy matter any more?

Is monetary policy really relevant today? This is the question that we need to ask. Since there are eight such policies or reviews during the year, there is a lot of primacy accorded to them.

Further, as the economy is not doing well, invariably all other arms of the government keep nudging the RBI to take action in a desired manner. There are naturally two views on interest rates which becomes the core of all policies and the RBI Governor either makes the market happy or unhappy by either decreasing or increasing rates.

There is a lot of criticism for either of the actions, as there are compelling views for both the actions. But, frankly going by what has happened in the last few years, if one looks at the issue dispassionately, monetary policy may not have mattered any which way. Let us see how.

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One must remember that interest rate is a very indirect tool that affects the economy. First, banks need to follow suit with their interest rates. At present, banks borrow around Rs 40,000 crore from the repo window, and hence even if it is borrowed for the full year, a 1 percentage point change in repo affects their cost by Rs 400 crore, which is not much.

[caption id=“attachment_1195439” align=“alignleft” width=“380”]  Do Rajan’s decisions really affect the economy as much as is claimed? AP photo[/caption]

A similar amount would be involved with the MSF change. Therefore, banks often take it as a signalling mechanism and may not really be affected by this change in cost in a significant manner when reckoning the base rate.

Second, borrowers need to come in or move out to have the desired effect even if banks follow the repo rate changes. If demand conditions are low or if they have spare capacity, they will not be interested in borrowing more when rates come down.

Here, expectations are important. If companies feel that rates will come down further, they would defer their plans. Third, higher rates can affect inflation only if borrowing comes down thus depressing demand for goods and services. All or some of these have to materialise for things to work.

Now let us see the Indian situation. The RBI has maintained that in FY13, it had lowered interest rates, yet we did not see growth take place. Therefore, the link between interest rates and growth is not strong.

This is so because at the present level of interest rates it made little sense to invest when there was surplus capacity given low demand conditions. The RBI was hence right when it argued that by merely lowering interest rates, one cannot bring about growth. In fact, it had brought out studies which argued the same.

Let us see the inflation impact next. While the RBI increased rates or kept them elevated, did it have an impact on inflation? Not really. Food inflation is high because of our pricing policies and possibly supply shortfalls at times (we are claiming a good prospective harvest this time again).

Fuel inflation is high because of higher rupee rate for crude oil on account of depreciation and changes in administered prices of controlled products. Core inflation, which is what theoretically what interest rates can affect, is low today.

If inflation numbers look marginally better than last year’s, it is the base year effect. The onion crisis has ensured that we cannot really argue that inflation has come down because of higher interest rates. Therefore, high interest rates do not bring down inflation. It helps in increasing real interest rates for households so that they save more in financial assets rather than gold.

It protects savers partly by raising real returns, but does not bring down inflation as no one borrows money to buy food or fuel.

The third angle given to monetary policy was the foreign factor. The tapering of the Quantitative Easing programmes was to substantially affect emerging markets where funds would pull out on account of the lowering of interest rate differential between domestic and US rates.

The tapering has not yet happened but central banks have used this as a reason for maintaining higher rates. But, in our case it has not really worked. Even though the exchange rate has strengthened, it has been more due to better trade numbers, more NRI deposits (enabled through the swap window opened) and equity investments by FIIs.

FII investments in debt remain negative even today. Quite clearly, higher interest rates have not quite helped to bring in more FII money though higher NRI rates have partly helped draw in deposits.

By intuitive reasoning one may conclude that higher interest rates have only partly affected the exchange rate, albeit in a very indirect manner.

All this means that while RBI and its interest rate policy are important, it is not a panacea for our present economic problems.

For credit growth to pick up, lower interest rates are not the solution, but demand is. The present move to increase consumer loans by lowering interest rates is a desperate effort to revive the credit spiral.

At the same time, using interest rates as a tool to tackle cost push inflation is also quite futile while there is justification for the same when we look at real interest rates.

The exchange rate will still be driven mainly by global factors, and trying to keep interest rates elevated may work at the margin, but foreign investors will surely be looking at the larger picture.

The thought here is really that one must view the RBI and its monetary policy as one part of the overall policy framework. Even in countries like the US, UK or euro region, lower interest rates have ceased to work to stimulate the economy which has necessitated measures like the quantitative easing programmes.

There are limits to the use of conventional economic policies when the travails are of an evolving and different variety. This is probably the lesson to be taken while different arms of the government work in unison towards a workable solution.

The author is chief economist, CARE Ratings. Views are personal.