Why the RBI won't do what it should: raise rates

By Shanmuganathan Nagasundaram

Not so long ago (read: 2005-06), many economic commentators in India and around the world were contemplating the job of central bankers. They observed that it has become a very boring task and concluded that the job of a central banker could well be automated. Little did they understand the underlying macro-imbalances lying in store as they more-or-less viewed the world from the perspective of a stable equilibrium.

The reasons for the above are easy to understand: most economists view the economy as operating in either of two mutually exclusive scenarios - a slowing economy on account of a fall in aggregate demand (which would require a loosening of credit by cutting interest rates) or an overheating economy leading to increasing prices (which would require a tightening of credit by increasing interest rates).

So what happens when there is a slowing economy and increasing prices? What should a central banker do when the twin problems present themselves simultaneously?

Before even answering the above question, such a situation should make economists sit back and look at the very foundations of their theory. But both John Maynard Keynes and the subsequent neo-Keynesian guru, Paul Samuelson, ignored the condition to suit their theories. Their dutiful students blindly ignore data that doesn’t fit their mental models. Just blame it on exogenous events, as they have done so far as an explanation for the stagflationary seventies.

So what should the RBI do today?

Ruminating on the above question, I would agree entirely with Robert Wenzel’s (Editor, Economic Polic__y Journal) recent speech at the New York Federal Reserve on the topic of central banking where he concluded by saying: “….I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths and four-legged rats”.

Much as I would like to live in a world without central banks, I understand it’s not even in the realm of a remote possibility today (but one that could very well become a reality over the next decade). So within the spectrum of possible actions, what RBI Governor D Subbarao should be doing is raise rates by at least 50 bps (0.5 percent) to contain the inflationary pressures building up and to ensure that savers are not penalised due to negative real interest rates.

Why so? As explained in a previous piece, RBI’s folly: why the markets will push up interest rates , positive real interest rates induce savings which are a prerequisite for investment. So when real rates are already negative, cutting interest rates further would lead to a reduction in savings by increasing the time preference scale. The investible capital base is going to shrink further, leading to lower investments and growth and by creating additional demand (due to the inevitable higher money supply). At a time of falling supplies, prices are likely to escalate. So cutting rates would lead to even higher prices and even lower growth.

Sure enough, the impact of a rate hike wouldn’t be pretty. The stock markets would dive, over-leveraged sectors such as housing, real estate and related industries would take a beating. But we are better off taking the medicine today and allowing the chips to fall where they may rather than getting deeper into the quagmire of mal-investment driven by artificially cheap credit.

What the RBI will do

The RBI is likely to cut repo rates by 50 bps accompanied by a reduction in cash reserve ratio (CRR) as well. While on the subject of CRR, it’s hard not to point out the fundamental fallacy of fractional reserve banking (FRB). Essentially and simply put, FRB is a ponzi scheme that operates with the due sanction of central banks. When banks lend money held under demand deposits (the reason they are known as demand deposits is that the money should be made available “on demand”), they are creating the illusion of savings that was never there.

Banks are just supposed to be a custodian of this demand capital, as happens in any warehousing operation. That the “good” under consideration happens to be fungible doesn’t in anyway alter the nature or function of the warehousing operation. Consequently, “bank runs” are an inherent feature of FRB and what Greece and Spain are witnessing these days is bound to occur sooner or later with banks around the world. More on that on a later date though.

Back to the issue of rate cuts. In a recent speech by Pranab Mukherjee, the finance minister pointed to two factors that he believes would help in growth: i.e., declining crude oil prices and a normal monsoon. It doesn’t take much to see that he is essentially clutching at straws by indicating his reliance on factors beyond his control. At least on one account, i.e. declining crude prices, he is likely to be disappointed as crude rebounds when the current artificial strength (which is primarily responsible for falling crude prices) in the dollar recedes.

So what actionable options does Pranab-da have to revive growth? Not a whole lot other than the faith that rate cuts will enable growth. That’s what he has been told over and over again by the economists in government and that’s what he is likely to press for and get his way on as well. As for those who still think central bankers are independent, what else can I say other than to point out that even the PM is anything but independent.

How it will play out

A rate cut by the RBI is likely to boomerang spectacularly in short order. Let me also speculate on how the obituary of rate cuts would look: the “automate central banking” economists/CII/other industry bodies that have been clamouring for a rate cut would say that the RBI tried its best to promote growth but unforeseen events caused the actions to fail. Pranab-da, or whoever is the FM a few months down the line, will blame the consequences on international factors.

Dr Subbarao will issue a statement on how the RBI will be proactive and vigilant on issues facing the nation. And as far as the saving middle-class goes, it will be yet another year of their savings debased.

Shanmuganathan “Shan” Nagasundaramis founding director of Benchmark Advisory Services, an economic consulting firm. He is also India Economist for the recently launched World Money Analyst, a monthly publication of International Man. He can be contacted at shanmuganathan.sundaram@gmail.com