Monetary Policy Managers, It Is Time For Aggressive Rate Cuts!

We’ve seen quite a lot of rate cuts from the Monetary Policy Committee (MPC) over the last couple of months but despite these rate cuts, our real interest rates continue to be as high as before.

The reason? Inflation has been far lower in 2019 than it was in 2018.

Therefore, what we have now is yet another prolonged instance of high real interest rates and a major reason behind this has been the slow pace of the current rate cuts. The fact that most commentators continue to ignore the monetary side of the economy is perhaps more concerning.

The important question to ask is if we will witness another rate cut and the answer to that is a definite yes!

With real interest rates at over 2 per cent, growth at 5 per cent and no signs of acceleration in inflation, there’s absolutely no reason for the MPC to not cut repo rates in its bi-monthly review next week.

It is not a rate cut that matters now, but the quantum of the rate cut and therefore, it remains to be seen whether the MPC will finally be a bit more aggressive than before. Do note, that in the previous bi-monthly meeting the Governor slashed repo rates by 35 basis points (bps) — or 0.35 per cent — from 5.75 per cent to 5.4 per cent.

The reason for a 35-basis-point cut was that 25 would have been too little while 50 may have been excessive. With the benefit of hindsight, perhaps the MPC would realize that a 50-bp cut would also have been too little and therefore, we should expect a necessary course correction.

Given that our current real repo rate is 2.2 per cent, we’re still 95 bps away from MPC’s neutral real rates — at which the monetary policy is neither accommodative nor restrictive.

The fact that we’re above it suggests that the monetary policy is, in fact, pushing the breaks just at the time we’re trying to take off!

Of course, it is still debatable whether 1.25 is the appropriate neutral real rate as many — including myself — continue to believe that it’s on a higher side. Therefore, what any sane analyst would ordinarily expect from a rational central banker is to at least have lower-than-neutral real rates at a time when monetary stance is accommodative.

India’s MPC, however, does things differently so it is difficult to predict whether even with course correction, we may go closer or below the neutral real rates.

There’s a need to realize that in the context of India we’ve seen the fiscal policy do a bulk of the heavy lifting in terms of economic growth while the monetary policy has been doing the opposite over the last couple of years.

There’s an urgent need to do the exact opposite going forward and now is the time for India’s MPC to realize that the output gap has only widened over the last couple of quarters.

Many central bankers in the advanced economies have expressed the inability of the monetary policy to stimulate growth as they look for fiscal measures. But the reason why monetary policy is of little use there is because of the prolonged low levels of real interest rates in most of these economies (some of them have negative interest rates).

This is in contrast with India and therefore, to use them as an example and argue for the ineffectiveness of monetary policy only ignores the characteristics, contexts and non-symmetric impact that economic policies have.

It is important to recognize interest rates, especially policy rates as cost of capital and therefore they do play an important role in determining competitiveness of domestic firms.

The other important variable is corporate taxes where we’ve witnessed remarkable progress!

On the rate cut next week, in my opinion, the MPC should at least go for a 50-bp cut. The economy does require a 100-bp cut given benign inflation; the question is whether it happens in two meetings or three.

A 65-bp cut may also not be a bad idea given that we’ve already tried 35! Therefore, if 50 looks too less and 90 is too much then, who knows, we just might get a 65-bp cut.