With August CPI rising to 3.4%, core inflation trending up and the base effect implying this will continue for several months, most economists seem to be arguing for a pause when it comes to rate cuts. Given how both RBI as well as professional forecasters have got it so wrong, it is not clear why these inflation forecasts have to be taken seriously—in the last 14 quarters, inflation has been overestimated by 180 bps in six quarters, and we are talking of just 3-month-ahead forecasts. More important, RBI seems to have forgotten that under the flexible inflation target, tolerable inflation levels are not just 4%, but 4±2%—that is, inflation can go all the way up to 6% without it being a problem.
RBI needs to understand why there has been a sharp compression in both private consumption levels as well as in investment. Right now, according to an analysis by former chief economic advisor Arvind Virmani, real interest rates are at a decadal high of over 6%; plot real interest rates against the growth in non-food credit and the result is, as expected, a perfectly downward sloping line. According to economist Surjit S Bhalla who has plotted this for 40 years, each 100bps increase in the one-year lagged real lending rate decreases growth by 40bps. What makes it worse, since higher interest rates spur FPI inflows, they also result in the rupee appreciating—the combination of higher interest rates and an appreciating rupee make India the perfect carry-trade destination. A strong rupee, in turn, makes imports cheaper and hits local manufacturing.
There are many who argue that while the role of interest rates may hold for consumption, few corporates are likely to invest at a time when corporate balance sheets are stretched and capacity as under-utilised as it is today. While that may apply to big-ticket investments, it is important to look at the reasons for the fall in investment levels over the past few years. While overall investment fell from 34.3% of GDP in FY12 to 27.1% in FY17, the biggest decline is not in investment by the private corporate sector—this remained more or less steady at 11%—but in ‘household’ investment which fell from 16% to 11%. While this includes small unincorporated companies, the bulk of this fall comprises fall in purchases of dwellings—while some part of this is related to a slowing growth in real estate prices, it is largely influenced by interest rates. And even if the corporate sector does not invest, a reduction in interest rates will lower financial stress.
Whether RBI will cut rates, of course, will depend on how members of the monetary policy committee react. The last time around, Michael Patra argued that “the financial environment is bubbly and frothy … a perfect recipe for a financial imbalance … a rate cut can amplify it if the central bank is seen as encouraging risk-taking” while Viral Acharya felt “higher real rates are justified in the meantime as absent efficient transmission, attempts to address symptoms of balance-sheet problems with aggressive monetary easing get wasted and can even backfire by misallocating investments, fuelling asset price inflation, creating false hopes of a growth boost, and relaxing the pedal on deeper structural reforms”.
Apart from the fact that RBI needs to encouraging ‘risk-taking’, lowering real interest rates has nothing to do with ‘misallocating investments’ since it does not affect the risk premium.