The Many Sides To The Interest Rate Debate
Minutes of the MPC meeting reflected the ongoing debate around food prices, the output gap and bad loans
The interest rate debate often ends up being a binary one. Rate cut or no rate cut. It has certainly been that way in recent months. The market has swung sharply from being upbeat about a rate cut in February, to turning despondent in April, and then seeing a glimmer of hope re-emerge in June. Through all of this, the conversation has focused on the headline inflation number falling below the Reserve Bank of India’s (RBI) projected trajectory.
The minutes of the monetary policy committee’s June meeting released on Wednesday, however, remind us that the current interest rate debate has many shades and sides to it. It is anything but binary. As an aside, it is encouraging to see an active debate on these issues within the MPC. After all, one of the ideas behind moving to a committee-based approach to monetary policy was that ‘six heads are better than one’. These six heads have collectively thrown a number of issues out for debate.
The one being discussed most actively right now is the drop in food prices, which has pulled down headline retail inflation.
Michael Patra, who is executive director at the RBI and the most hawkish member on the committee, asks a simple question. Do we expect the current bout of deflation seen in the vegetables and pulses to be the ‘steady state’?
Patra’s answer to that is no.
Not when agricultural wages have risen by 8.5 percent, farm input costs by 10 percent, bank credit to agriculture by 13.5 percent in the year just gone by and the output gap in agriculture is turning positive on rising rural incomes!Michael Patra, Executive Director, RBI
The normally soft spoken Patra even adds an exclamation mark to his comments for good measure.
Patra’s view, at least on pulses, is supported by data. DK Joshi, chief economist at Crisil, in a November 2015 report, had highlighted that pulses inflation tends to follow a three year cycle. Higher prices lead to increased output, which pushes down prices and then output. This has played out over and over again, shows the data.
Ravindra Dholakia, who sought a 50 basis point cut, chose to focus on the immediate inflation data, which is running below forecast. That, together with softening inflation expectations, gives the central bank room to reduce interest rates. It should use this window before it closes, argued Dholakia.
The emerging fiscal situation has opened another front in the inflation debate.
For the last few years, the central bank has taken comfort in the central government sticking to a fiscally conservative stance, even though at times it has questioned the quality of fiscal consolidation. The comfort on the fiscal front, however, appears to be disappearing. In its May 12 report on states finances, the RBI noted that the deterioration started in 2015-16, when the Gross Fiscal Deficit-Gross State Domestic Product (GFD-GSDP) ratio hit 3.6 percent, crossing the threshold of 3 percent for the first time in a decade. While a renewed attempt at fiscal consolidation was expected in 2016-17, the RBI said that the fiscal deficit ratio of states was likely to remain high at 3.4 percent.
This was before the wave of farm loan waivers hit us.
“...the rising fiscal risks due to growing demand for farm loan waivers also pose a risk to inflation,” wrote RBI governor Urjit Patel in his statement included in the minutes of the MPC meeting.
Patel highlighted an interesting statistic in this regard, which perhaps show that the high level of indebtedness may lead to a spate of farm loan waiver demands.
Outstanding advances to agriculture and allied activities, as a ratio of GDP from agriculture and allied activities, has increased from about 13 percent in 2000-01 to around 53 percent at present.Urjit Patel, Governor, RBI
Others like Viral Acharya and Pami Dua also brought up the issue of farm loan waivers, in light of the fear that this fiscal profligacy could lead to inflation down the road.
Dholakia, however, countered that by saying that states are bound by their own fiscal responsibility legislations and will think twice before become fiscally irresponsible since it will impact their market borrowing costs. This, unfortunately, has not held true as the market has failed to distinguish between states in pricing their borrowings.
The MPC’s debate around interest rates also extended to getting a fix on the so-called ‘output gap’, which tells you how the economy is growing relative to its potential.
Here again, there was a divergence of views.
Chetan Ghate noted that while the recent slowdown, brought on by demonetisation, may suggest that the output gap has widened, this may not be the case. If the growth effects of demonetisation are expected to be transitory, as both the RBI and the government maintain, then there may be no reason to believe the output gap has widened.
Dholakia, however, pointed to the fact that capacity utilisation has been below 75 percent for some time, which indicates the existence of a large output gap. Patra was with Ghate on this count and said that if growth is expected to rise to 7.3 percent in fiscal 2018, then the output gap is narrow and may eventually close.
In the midst of this debate, governor Patel cautioned against trying to glean too much from the ‘national’ output gap.
A third sub-debate that entered the broader debate on rates was on the implications of the banking crisis on interest rate policy.
This debate was led by deputy governor Acharya.
Acharya had a couple of points to make. One, being that lower interest rates have so far failed to translate into higher private investment due to the overhang of debt. Since that overhang has not been resolved, any further rate cuts will also have limited impact. If anything, they may make it easier for banks to evergreen bad loans. Patel, too, leaned in and suggested that a resolution of stressed assets is almost a precondition to a revival in private investment.
Finally, Acharya countered arguments made that lower interest rates will help banks out of this mess quicker.
Some suggest that monetary policy should be eased with the explicit objective of recapitalising the weak bank balance-sheets. Nothing could be worse for monetary policy, in my view.Viral Acharya, Deputy Governor, RBI
The differing views within the MPC may have left bond market participants confused on what to expect from the next monetary policy meet, but have certainly added depth to the debate around economic conditions. That can only be a good thing.
Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.