RBI has finally come out with a pro growth policy after realizing its utter helplessness in controlling headline inflation driven by high food & fuel prices and most importantly after taking into account the impact of past adjustments on current inflation. Some examples of past adjustments impacting current inflation figures are –
  •           Brent crude prices are at the same level of last year and the INR is also at the same level, however the headline fuel inflation in India is over 9% and likely to move up further over the next couple of months given the Diesel price hike.
  •           Non Urea fertilizers deregulation of prices has added nearly 0.4% to headline inflation. However fertilizer prices globally have been stable over the last year.
  •           Electricity price hike by most SEB’s, in some cases after years has added nearly 0.5% to headline inflation. However most of this adjustment is due to prior periods.
  • Added to this is the impact of the excise duty hikes in the last budget which added approximately 1% to the headline inflation.

As such if we evaluation the current headline inflation in the context of the above, if prior period adjustments were not there the headline inflation would be trending at around 5.5% today despite the significant food inflation. This is not to say that the prior period adjustments should not have been done, these were much overdue and overall from a macro economic standpoint the more are the actual prices in the market place nearer to the real prices the better it is. However from a policy maker’s standpoint, they need to take all these factors into account while demarking the demand driven inflation from reported inflation figures.
Now coming to the main point of the current article. While RBI has clearly recognized that the government is now working in a responsible manner as far as macroeconomics is concerned the same recognition does not seem to be shared by the influential “Armchair economists” who tend to have a significant influence on RBI policies for some reason beyond my understanding. As I have been reading a number of pieces written by them in the newspapers my conclusion is that they people are totally out of sync with reality and how the economy actually works. There is a need to distinguish between the disease and the reasons behind the disease. India continues to have the highest nominal interest rates relative to the last cycle among most major economies. However this has not resulted in lower inflation despite a significant demand slowdown driven by factors like –
-Free global money that has inflated commodity prices much beyond what is justified given global demand conditions
-The factors on deregulation of regulated prices as mentioned earlier
-Populism and fiscal irresponsibility by the government
These plus some other factors.
Now a major reason being propounded by the Armchairists for not lowering interest rates is that it discourages saving and will have an impact on current account deficit. Both these arguments are actually untrue. There is a continuous outflow of INR liquidity out of the country due to the high Trade Deficit and that is a reality. However that this outflow will stop if interest rates are one or two percentage points higher is totally ridiculous. However it is true that the higher inflow into Indian Government Debt is due to higher coupon rates relative to global interest rates. Under the circumstances what needs to be actually evaluated is whether the higher domestic interest rates are actually benefitting domestic savers who are actually not putting money into financial savings while putting disproportionate amount of money into gold and real estate. The major benefit seems to be going to foreign investors who have been pumping money into Indian Debt instrument while being scared to put money as equity. Now this is clearly dangerous from a long term standpoint where we need growth capital rather than debt capital for the economy. What is going to happen as interest rates come down? The foreign investors will make both capital gains and coupon on their investment in risk free government debt. When double digit returns can be made in risk free instruments, why take risk?
By keeping liquidity constantly in deficit the RBI is contributing to the continuous fall in M3 as well as reducing the money multiplier. Since the RBI statement yesterday has clearly said in their own words that the inflation is no longer demand driven they need to move fast now to get the liquidity deficit into either surplus or at least to a no Repo borrowing stage. This will improve the money supply in the system and could start a virtuous cycle.
The other part of the strange reporting as well as expert commentary is that the impression is being given that the RBI has indicated that further cuts are contingent on some factors. However my impression of what was said is that the RBI is saying that there are going to be more cuts going forward if things do not actually deteriorate. The other, and which is the most ridiculous commentary is that rate cuts will lead to demand revival and due to lack of capacity addition this will again lead to inflation. Now, besides government apathy and the environment ministry one of the major reasons for the lack of capacity additions is the lack of faith about future economic growth and the high interest rates. As interest rates moderate capacity addition will become much more feasible as capital costs come down. So, does the solution lie in controlling demand which is already low or does it lie in creating capacity?
We actually need to attract long term capital into the country, preferably into infrastructure projects. However given the bottlenecks associated with these projects and also the delays it has become difficult to do that. This should actually be the priority for the government as this will take the flows away from debt flows.
To conclude, RBI driven by the logic of Armchair Economists has contributed to economic growth going much below trend rate and now more near the so called Hindu Rate of Growth. The government on its part also has been a strong contributor to the slowdown but now seems to be getting its act in place. Yesterday’s action by the RBI also seems to indicate that they are also getting their act in place. Let’s hope that they also stay the course now.  

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