Why RBI was right in ignoring Modi government and holding rates

It is a positive gesture, reinforcing the central bank's credibility dented by the demonetisation exercise of last year.

 |  5-minute read |   12-06-2017
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Media reports last week had suggested that the Modi government had called for a meeting with members of RBI's monetary policy committee (MPC) just ahead of the policy meet.

The move was described as a government attempt to meddle with and influence RBI’s interest rate decisions.

But the meeting did not happen as the MPC members declined the request of the finance ministry for taking part in such a meeting to take ministry instructions.

RBI governor Urjit Patel’s unprecedented public assertion of his independence to hold rates and stick to inflation focus until 2018 is seen as a positive gesture to reinforce the RBI’s credibility - already dented by the demonetisation exercise last year.

So does the 50 basis points cut in the statutory liquidity ratio - the share of total deposits bank are expected to invest in government bonds - to 20 per cent, effective from June 24, for enhanced monetary policy effectiveness.

The RBI chief was correct in playing down the policy outlook to neutral without actually playing his rate cut stroke despite chief economic adviser Arvind Subramanian's rosy campaign for a rate cut.

Subramanian has in the past sparred with former RBI governor Raghuram Rajan on rate cuts and central bank surpluses. According to him, headline as well as core inflation has declined sharply and the inflation outlook has been rendered benign by a rising currency, good monsoon and capping of oil price increases by structural shifts.

The chief economic officer of the government’s view is based on the construct that inflation forecast by the RBI has been largely both erroneous and systematically one-sided, in overstating inflation.

He foresees a benign inflation forecast in contrast to RBI’s insistence on continuing upside risks to inflation.

Here are four major reasons why the RBI was right in opposing the government and holding back an interest rate cut:

Loan waiver and higher minimum support prices for farm goods

The threat to the Centre's fiscal discipline is on firm ground, with the relief  package for farmers announced by the Madhya Pradesh government following the Uttar Pradesh government's similar stand and Maharashtra's comparable attitude.

It all shows that BJP-ruled states are themselves on shaky fiscal basics.

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Demand for higher minimum support prices for farm goods also holds a cost-push inflation threat, which puts the ball back in the court of the CEA for course correction.

Volatility of oil prices

Geopolitical risks such as Saudia Arabia and some other Arab nations cutting off diplomatic ties with Qatar possibly putting pressure on import bills for India, Islamic State militants attacking Iran's Parliament etc, are not significant enough to cause an oil shock, traders are still worried about a West Asian output cut that can force up oil prices.

Monsoon concerns

The RBI policy review after the monsoon rains in the olden days used to be called the "busy season" policy as it helped policymakers reduce agriculture-related risks. It makes sense for the RBI to wait out the rainy season now as well, before deciding firmly on further rate cuts.

GST worries

While the government expects GST to bring down inflation, the international experience is that it causes inflation to go up in the initial stage of its introduction in the first two-three years. One time bump in inflation is to be expected otherwise also, even as indirect tax collections swell.

The other side of GST is that higher service tax rates, higher rates fixed for many consumables, keeping out some items from GST such as petroleum products, electricity, real estate, start-up hiccups in GST implementation, and the possible inflation bulge in the initial months (that will dissolve in subsequent months) are all expected to add to the upside risks of inflation.

Given all this, the RBI governor holding interest rates for a while appears to be a sound policy decision by him and the MPC. This realism is seen as a more useful sentiment than the romantic expectations in North Block that may fail to hold any water immediately by cutting rates.

It is further not so much by a rate cut that one could hope to have immediate, direct impact on growth as the major combinations of overleveraged corporates and banks’ bad portfolios.

The central bank cut its forecast for consumer price inflation in the first half to 2.­35 per cent from 4.5 per cent and to 3.5­4 per cent from 5 per cent in the second half.

Other factors contributing to inflation

Rising demand for farm loan waivers and sticky core inflation due to rising rural wage growth are seen by the regulator as potential risks for fiscal slippage, apart from the support prices for farm goods recommended by the government and 7th Pay Commission award implications.

The rise in agricultural stock to over 60 million tonne is a dual threat: lower supply of foodgrain in the market pushes up prices directly and larger food subsidy bill produced by higher food grain stocks is a strain on fiscal discipline.

However, defending the government, finance minister Arun Jaitley said the Centre’s move to meet with or convey the government’s point of view to MPC officials is its duty.

He added that the finance ministry represents the government of India and it is well within its rights to convey the government’s point of view whether orally or in writing.

He said in the end, the government respects the RBI’s decision and any decision on interest rates is within the central banks' jurisdiction.

We too must therefore repose confidence and trust in the wisdom of RBI in not hurriedly pushing for a rate cut but continuing a neutral stance.

Also read: Urjit Patel needs to save reputation of RBI which demonetisation damaged

Writer

K Srinivasan K Srinivasan @krishsri59

The author is a GST reader and writes on macroeconomics and indirect tax laws.

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