The new RBI Governor Urjit Patel delivered the much awaited rate cut on his first monetary policy review on Tuesday. This was also the first time the policy was decided by the RBI panel of six, which includes three economists from outside the central bank — Chetan Ghate, Pami Dua and Ravindra Dholakia. The idea of forming a panel to decide on policy rates was ex-RBI Governor Raghuram Rajan’s.
The logic behind the rate cut was that the beast of inflation had been tamed — at least for the time being. The 25 bps cut on repo rate was predictably cheered by the industry captains and the media. But whether this rate cut leads to a boost in lending and investments remains to be seen. This also crucially hinges on ‘monetary transmission’ — whether the banks follow RBI’s cue and reduce lending rates.
Inflation hawk
Patel’s predecessor Rajan was known to be an inflation hawk. During his stint at Mint Street, despite repeated calls from the industry and some not-so-subtle hints from the Finance Ministry, Rajan still steadfastly held his own and started cutting rates only after he felt that the inflation threat had receded.
Patel’s appointment as RBI Governor was widely welcomed. After all, he served as a Deputy Governor and was very much an insider; and even he was described as an inflation hawk by the media.
So has a rate cut in his very first policy review hint at a subtle shift from the previous regime? Or has the inflation threat really receded?
Diluted stance?
Analysts at Japanese investment bank Nomura certainly feel that the RBI has diluted or ‘tweaked’ its stance on inflation. In a report titled, India: New RBI dilutes old RBI framework , economists Sonal Varma and Neha Saraf say, “We believe that there has been a dilution of the tenets of flexible inflation targeting framework under the new regime compared with the old regime.”
They further go on to argue: “Under the old regime, the RBI was clear about lowering inflation to 4 per cent by March 2018. Now the interpretation of the inflation mandate appears to be to keep inflation within a range of 4 per cent (+/-2 per cent) over the next five years, which is too wide a range without a specific time commitment to the midpoint.”
But much like the fiscal deficit target, the inflation target can also be a bit arbitrary, as there is nothing really sacrosanct about these numbers. These work as mere indicators and in the case of inflation, we mostly work within a range.
Economic phenomena
Inflation is one of the most complex and least understood economic phenomena. Despite the phenomenal improvement in data collection and statistical and forecasting techniques, we are still unable to get a complete understanding of why and how prices move.
Economist Kaushik Basu in his recent book An economist in the real world, devotes an entire chapter on inflation, which goes by the interesting title of ‘Inflation: The emperor of economic maladies’. It’s not surprising that he has devoted an entire chapter on inflation, as it was during his stint as chief economic advisor of the Finance Ministry that inflation remained stubbornly high, during the UPA II regime.
He is quite candid in saying that when it comes to controlling inflation, policy makers largely rely on rules of thumb. And the reason they work, at least partly, is because of practice and evolution. To quote Basu, “We get our monetary and fiscal policies right, partly, in the same way that birds get their nest building right.” Economists are rarely this candid about their capabilities.
Given how complex the issue of inflation is, and with a myriad set of factors influencing it, monetary policy may not always work in taming it. Policy makers may have to look at alternative policy options, including demand management.
Wait and watch
Policy makers cut rates hoping that it would immediately lead to a reduction in lending rates, which in turn will fuel the demand for credit, leading to an increase in investments. The operative word here is ‘hope’.
As the industrialists’ investment decisions are based on a number of complex factors, where the cost of credit is just one of them, a simple rate cut may not necessarily increase investment activity — at least, not in the short term.
But one can hardly blame policy makers for that, as they often have only limited tools to work with and even less control over the bewildering number of variables functioning in a vast and diverse economy like ours.
So at the risk of sounding trite, one will have to wait and see whether the new RBI Governor’s ‘cut shot’ goes to the boundary. Now that industrialists have got the rate cut they were clamouring for, to use another sporting cliché, the ball is now in their court.