An appropriate call

Significant fiscal slippage could affect monetary policy

The monetary policy committee (MPC) of the Reserve Bank of India (RBI) on Friday reduced the policy repo rate by 25 basis points (bps), largely in line with expectations, though some participants were looking forward to a bigger cut. The MPC has done well by not going overboard with a deeper cut to address the economic slowdown. The central bank also reduced the projected growth in gross domestic product (GDP) for the current fiscal year to 6.1 per cent from the previous forecast of 6.9 per cent. 

It could be argued that a sharp downward revision in the growth forecast warranted a bigger rate cut, especially when the inflation rate is likely to remain under 4 per cent. Even without a sharp downward revision in the GDP growth projection in its last meeting, the rate-setting committee had lowered the policy rate by 35 bps. However, there were strong reasons why a rate cut of 25 bps was more appropriate this time. Before last week’s policy action, the MPC had reduced the policy rate by 110 bps in the current cycle, which has not been transmitted fully into the system. While the weighted average lending rate on fresh loans of commercial banks between February and August came down by only 29 bps, the rate for existing loans went up by 7 bps. Since the transmission is extremely slow, it made sense to preserve some policy space and allow the system to adjust. The linking of lending rates to external benchmarks for a set of borrowers should improve transmission, even though it could lead to a different set of challenges for the banking system. Also, it is sensible to conserve some policy space in an increasingly uncertain global environment. The Monetary Policy Report — also released on Friday — showed that a decline in global growth by 50 bps from the baseline could pull down growth in India by 20 bps.

Furthermore, although RBI Governor Shaktikanta Das argued that the central bank had no reason to doubt the government’s commitment to contain the fiscal deficit within the stated limit, it is possible that members of the MPC would have considered the possibility and implications of a fiscal slippage. MPC members have expressed concerns over fiscal management in the past. Chetan Ghate in the August meeting, for instance, noted: “I continue to worry that fiscal imbalances embodied in our large public sector borrowing requirement (roughly 8-9 per cent of GDP) will lead to detrimental outcomes for the economy. While a fiscal glide path should be seen as a limit … Convergence to the limit happens, and a form of ‘creative accounting’ kicks in.” Indeed, a significant fiscal slippage could affect the inflation outlook and monetary policy choices.

Nonetheless, both stock and bond prices fell after the rate decision, partly because of concerns about lower growth and expectations of a deeper cut. Although the MPC has stated it will “continue with an accommodative stance as long as it is necessary to revive growth”, the markets would now want to know as to what extent the policy rate could be reduced. Clearly, an accommodative stance doesn’t mean that the MPC will cut the policy rate every two months. It is not clear how far the central bank would be willing to lower the real rate to support growth. The MPC would soon need to deliberate on this issue. More clarity will not only help improve transmission but will also anchor longer-term inflationary expectations. Communication is a powerful instrument in the toolkit of modern central banks and should be used effectively.