In my last article, I had argued that despite the drop of 0.25 per cent in the repo rate, real interest rates in India still seem too high, limiting the actual output (and job creation) below its potential. I was pleasantly surprised to see economist Helene Rey emphasising the equivalence between output loss and high real rates in her Andrew Crockett Memorial Lecture last month — “The Global Financial System, the Real Rate of Interest and a Long History of Boom-Bust Cycles”. In it, she quoted Larry Summers’ argument that “we had entered into an age of ‘secular stagnation’, that is, an era where output remains chronically below its potential, or equivalently, real rates remain above their natural rate”. To be sure, she was talking about advanced economies, but is not the point equally relevant for us?
She also stressed that “key countries’ monetary policies affect other countries’ monetary conditions and financial stability in several ways. Financial imbalances may arise. Or the presence of foreign financing may lead to powerful balance sheet effects that will alter the transmission channel of domestic monetary policy”. In other words, it is not only the inefficiency of our bankers that leads to poor transmission of policy rate changes to borrowers, something which the central bank is trying to remedy through a revised marginal cost of lending rate mechanism. She made one more point relevant to our inflation target approach: “Monetary spillovers may conflict with the domestic mandates of central banks”.
As for the exchange rate, are our policymakers making the same mistake which the Bank of England did in 1921 in restoring the gold parity of the pound to its pre-war level, ignoring the inflation that had occurred in between? This led to a deep recession in the UK, and a million and a quarter unemployed. According to the CMIE, we lost 1.5 million jobs between January and April 2017 at a time when, given our demographics, we need to create a million jobs a month. Surely, this was partly because of an uncompetitive exchange rate? (The rupee has gone up further since April). Are we paying a heavy price (and could pay an even heavier one) to retain the confidence of international portfolio investors in order to meet the inflation target? Inflation hurts the poor the most, but does unemployment not hurt them even more? We should not forget that, as Rey argued (ibid), “International investors appear subject to sharp swings in sentiment: During ‘risk-on’ periods financial capital flows across boundaries, leading to increases in risky asset prices and more leverage. This process can reverse sharply during high-volatility ‘risk-off’ periods.”
The Economic Survey Part II, which was published last Thursday, apprehends the possibility of deflation (that is, negative inflation) as against the Reserve Bank of India (RBI) estimate of four per cent plus for Q2 and Q3 of the current fiscal year. It also makes the point that the real interest rate is very high, and the targeted economic growth may not be reached either in real or nominal terms. The survey makes the point that over recent quarters the central bank has overestimated inflation in the following quarter, on an average, by 1.8 per cent — in other words its forecast was wrong by an average of 40/50 per cent!
For an economy like ours, which needs to create a million jobs a month, even a seven per cent growth would be equivalent to “secular stagnation” for advanced economies. As it is, factory output is at a 48-month low in terms of the latest Index of Industrial Production number; the worst affected sector is capital goods, suggesting lower investment and hence, lower future growth. This clearly has adverse implications for (this year’s and future) revenue, which has already been hit by a lower RBI dividend to government (its profit has been hurt by the translation losses on foreign currency reserves because of the rupee appreciation). According to the Economic Survey, 50 per cent of the private investment in thermal power plants is unviable. Add to this other non-performing assets, the farm loan waivers, the capital needed by public sector banks to meet the Basel capital norms etc and the demand on fiscal support goes up further. In the absence of such funding, lending growth will remain anaemic. All this will affect the government’s ability to give fiscal stimulus to the economy thanks to the deficit target linked to the nominal gross domestic product; 80 per cent of the budgeted deficit has already been exhausted in Q1.
Are monetary policymakers focusing only on the inflation target overlooking that their mandate also includes growth?
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