Inflation and interest rates: What is the Reserve Bank's policy?

A comprehensive technical framework needed, from which a more convincing policy could be demonstrated

The December 2 Fifth Bi-Monthly Monetary Policy Statement, 2014-15, from the Reserve Bank of India (RBI) declared, “On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to: keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at eight per cent ...”, etc. Unfortunately, that “basis” remained unexplained: what is the background framework for the Indian economy based on which the RBI came to the conclusion as most central banks do?

That was followed by the RBI’s assessment of the economy – comprising a lament of negatives – clearly inconsistent with a continuation of its tight-fisted interest rate policy. It admitted to a “slowdown” in rural wages, a “slump” in the growth of industrial production, a “persisting contraction” in capital and consumer goods production, “deceleration” in new business in the services sector, all leading to “weak” aggregate demand, a “critical” need for rise in investment, “still slow” pace in reviving stalled projects, a “deceleration” of exports since July, and a need to ease “stress” in the financial system since banks are “flush” with funds.

What further consternation is needed to move the RBI into action? It is surprising that the ministry of finance made inaudible noises at this unfortunate development obviating wide-ranging anticipation. Unless the finance ministry initiates serious independent evaluation, the economic plot of the new government may soon be lost. Let me elaborate.

The RBI blamed the need to adhere to its conservative interest rate policy on weak tax revenue growth and slow pace of divestment. It does not take a trained economist to see that the economic morass the RBI itself described provides ample explanation for why there are no takers on the horizon for divested units and why tax revenue should be low in this ebb cycle unless the same extortion from taxpayers continues under the new government through stopping or delaying refunds and input tax credit, demanding unwarranted pre-deposits, and preponing tax payments through diktat in the last quarter, in other words, through pervading taxpayer harassment carried out through policy imposition on the tax administration.

Indeed the RBI’s observation, that “the government, however, appears determined to stay on course”, seems somewhat supercilious. What about an optimal combination of monetary/fiscal/exchange rate policies, as well as bringing in real sector and trade policies into the matrix in an evidence-based manner?

The RBI’s justification for its inaction on the interest rate front despite “dissipating headline inflation” was, “the key uncertainty is the durability of this upturn”. This gives rise to curiosity to examine recent data. Figure 1 fits a polynomial on the Consumer Price Index (CPI), the Wholesale Price Index (WPI) and CPI (Industrial Workers), or CPI (IW), observations between April 2011 and October 2014.

CPI and CPI (IW) have declined from Q4 2013-14, and WPI has declined since Q1 2011-12 (beginning of the statistics depicted). This enables observation of real interest rate trends in figure 2. The polynomials reveal that the real median base rate of scheduled commercial banks – which has immediate relevance – has been positive and rising from about Q3-Q4 of 2012-13 with respect to CPI and CPI (IW) and from Q1 2011-12 itself with respect to WPI. Given the uncontestable lengthy periods for which price indices have declined and interest rates have risen, what kind of “durability” is the RBI waiting for?

Fitting polynomials to other interest rate trends – given their fickle movements – was not found to be so revealing. Hence figure 3 simply depicts the real base rate trends with respect to CPI, CPI (IW) and WPI. Reflecting the continuing decline in WPI (see figure 1), it is not surprising that the real base rate has been throughout positive and rising with respect to the WPI since Q1 2011-12, with further sharp rises from Q3 2013-14, while, with respect to CPI and CPI (IW), the real base rate has been positive and sharply rising from Q4 2013-14.

Separating the rate into rural and urban yields similar trends (not shown). Further, the lower range of the real base rate follows the same trend just below the higher range rate (figure 4), in fact, almost coinciding since Q4 2013-14.

Figure 5 shows the trends for real policy repo that the RBI talked about. The repo is the rate at which the RBI lends overnight to banks against collateral. It affects all other rates, and is the rate announced in the policy statements. Here, with respect to WPI, the real policy repo rate has been positive from Q3 2011-12, a long period, and has been rising significantly from Q3 2013-14.

With respect to CPI (IW), it has been positive and rising since Q4 2013-14 and, with respect to the CPI, it has been positive and rising since close to Q2 2014-15. The latter is the rate that the RBI cited, but its position is easily countered by citing other relevant real rates illustrated above that have been positive for a significant period already.

Indeed most real interest rates have been rising – reaching almost five percent with respect to some indices and slightly less so with respect to other indices, all of which are of relevance to borrowers – and during a significantly long downturn in economic activity. When all relevant borrower interest rates are considered together, the RBI’s textbook interest rate policy demands immediate abandonment and substitution by a more accommodating policy. Indeed it is fallacy to call such improved policy “accommodating” since it is the only correct policy at this point.

One concluding suggestion for the RBI. Let its two-part inflation projection comprising base effects obtained from inflation momentum and time series for future momentum (Monetary Policy Report, RBI, September 2015) be supplemented by a comprehensive technical framework from which a more convincing interest rate policy could be demonstrated. India awaits conviction through appropriate analysis for the RBI’s conclusions. Let the RBI change course.