MPC Meet: Why RBI should step back and reduce interest rates

The RBI has prohibited financial institutions from charging penal rates on loan defaults or non-compliance with credit terms.

By lowering the purchasing power of households, inflation which is nothing but indirect taxation, discourages consumption which remains the backbone of the Indian economy. Furthermore, sluggishness in consumption caps private investment, and in turn GDP growth. That calls for containing inflation on a priority basis.

However, to devise effective policy measures to contain inflation, a thorough diagnosis of the problem is imperative.

Inflation Issues

In its current form, inflation in India is more about deficient supply, especially of perishable horticultural produce and not excess demand. Populist hikes in support and procurement prices of cereals add to the complexity of food inflation and reduces the effectiveness of monetary policy moves.

Since the cause of inflation is not excess demand (rather consumer demand remains weak if the latest GDP data is any indication), measures to control demand i.e. tighter monetary policy, will have a limited impact if any on prices, especially on food prices.

Moreover, with weak consumption -- which is likely to continue in the near term as most forecasts hint at, high interest rates actually hamper the credit-financed demand for relatively high valued discretionary items such as automobiles, consumer durables and residential homes. That in turn, caps the growth prospects of multiple industries having strong backward and forward linkages with these key industries.

Price Rise a Problem

As mentioned above, India’s inflation is primarily caused by sharp increase in food prices that in turn is caused by i) populist hikes in support and procurement prices of cereals, and ii) wild seasonal swings in supplies of perishables such as vegetables and fruits, which in turn is caused by unpredictable weather patterns and increasing price risks for growers in the absence of assured procurement, unlike sugar cane and cereals. Knee jerk reactions leading to ban on exports further increases price and income risks for farmers, more so in the absence of adequate storage infrastructure, cold chains in particular, and in turn disincentivise cultivation of perishables and weakens supply responses to changes in their prices.

Besides, taxing the whole transportation ecosystem exorbitantly, be it fuels, vehicles or motor insurance has been increasing the cost of moving goods, and in turn transmitting cost-push inflation in every part of the Indian economy.

The post-meeting commentaries of the monetary policy committee (MPC) hint that it remains wary of food inflation, and not without reason. However, there is nothing the RBI can do to control it. Furthermore, while keeping interest rates high may not help contain food inflation, it will certainly discourage private capex by discouraging credit financed demand for discretionary goods and services from demand side and increased cost of capital from supply side.

Lower Interest Rate to Fight Inflation

Thus, it’s time for the RBI to drop its hawkish stance and start cutting interest rates. This move will benefit both producers and consumers, and yet will have insignificant adverse effects on inflation. A relatively stable Rupee further reduces the external costs of interest rate cuts, specifically for the rupee’s exchange rate, which has not fallen much: it was 82.19 on April 2, 2023, and it is 83.44 now, representing a fall of 1.5% in 12 months. It’s also sensible for the central bank to look at core inflation (and not headline CPI inflation as it can’t really control food and fuel inflation) when deciding on contours of monetary policy. Core inflation fell to 3.3% (YoY) in February from 3.6% in January.

Moreover, both central and state governments also need to walk the talk and cut fuel taxes to reduce shipping and transportation costs, which are a major factor contributing to cost-push inflation in the country. The government also needs to focus on creation and upgrade of post-harvest infrastructure to cut farm produce wastes and extend the shelf-life of perishables. Similarly, instead of continuing with populist pricing of cereals, the government should focus on how to raise farm productivity which is shamefully low for most crops grown in India. Raising farm productivity is the only long-term solution to raise farmers’ income in a non-inflationary way. The RBI has a limited role to play here, and therefore it shouldn’t come in the way of boosting private capex and credit-financed demand for discretionary goods and services.

It's also worth mentioning that a tighter monetary policy tries to check demand and, in turn, prices. However, a restrictive trade policy (to control imports in order to support indigenous producers) constrains supplies and aids cost-push inflation. Given this backdrop, there’s an urgent need for proper coordination between monetary and trade policy measures.

Ritesh Kumar Singh is a business economist and CEO, Indonomics Consulting Private Limited, a policy research and advisory startup. He tweets @RiteshEconomist.