EDIT: BREAK WITH CONVENTION

There are limits to what monetary policy can achieve

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) on Wednesday surprised many market participants by reducing the policy repo rate by 35 basis points, making it the fourth reduction in a row. The central bank also lowered its growth forecast for the current year to 6.9 per cent from 7 per cent. The MPC doesn’t expect inflation based on the consumer price index to cross 4 per cent at least until the first quarter of the next financial year.

The central bank’s idea of breaking with the convention of adjusting rates by 25 basis points, or in its multiples, can be traced to a speech delivered by RBI Governor Shaktikanta Das in Washington DC earlier this year, when he had noted: “… in a situation in which the central bank prefers to be accommodative but not overly so, it could announce a cut in the policy rate by 35 basis points if it has judged that the standard 25 basis points is too little, but its multiple, i.e. 50 basis points is too much.”

The MPC’s decision was explained by similar reasoning. However, the move needs to be debated. For instance, would the action of the central bank not become more unpredictable, and how will anyone benefit from this? Also, it is not clear how an additional 15-basis-point rate reduction would have been excessive, given that the economy is showing clear signs of weakness, inflation is expected to remain muted until at least the first quarter of the next financial year, and when “[A]ddressing growth concerns by boosting aggregate demand, especially private investment, assumes the highest priority...” for the central bank.

Aside from cutting the policy rate, the central bank has sought to free up banks’ capital by easing norms that will allow them to lend more to nonbanking financial companies. This would not only help these firms but will also improve the flow of credit in the system. However, the big question is: To what extent will the break with convention help revive growth? It is likely that growth in the current year would be significantly lower than the RBI’s projection. The global outlook has worsened in recent days with increasing trade tension between the US and China. The ensuing uncertainty will further dampen the outlook for global growth.

Besides global headwinds, internal drivers of the economy are also not indicating a quick revival. The central bank is doing its part by progressively reducing the cost of money. However, it will not be enough simply because there are limits to what monetary policy alone can achieve. Also, the economy is not fully benefiting from lower policy rates because slow transmission remains an issue, partly owing to excessive borrowing by the public sector. The government seems to be on the same page on this and has advised public-sector banks to commensurately transmit rate cut benefits in lending. But the government obviously has to play a larger role. It is important at this stage that policies in the area of fiscal management, trade and exchange rate management are reassessed. Further, a flexible land and labour market remains elusive. The global environment is undoubtedly challenging, but India can only improve its standing by enhancing competitiveness.