Flagging recovery

Another rate cut will not help at this point

Flagging economic recovery would be a key concern for the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), which is meeting to review the policy this week. The Manufacturing Purchasing Managers’ Index, for instance, fell to 46 in July against 47.2 in June. Although a reading below 50 indicates contraction, the latest print suggests firms are facing difficulties and economic activity would remain muted until the virus is contained. A number of states have imposed localised lockdown, which is affecting supply chains and consumer demand. Other indicators also underscore this. Mobility indices, which track movements of people, have declined. A recent note by Nomura highlighted that economic recovery, measured by an index, is stuck at about 30 percentage points below normal.

Goods and services tax collection in July was lower by 14.6 per cent, year-on-year, as a large part of the service economy is still not allowed to operate. Car sales recovered sharply in July, but may not be reflecting the correct picture. Since producers report dispatches to dealers as sales, one-month data may not reflect the actual demand situation. However, the employment situation seems to have improved significantly. The unemployment rate, according to the Centre for Monitoring Indian Economy, fell to 7.43 per cent in July, which is lower than the level seen in February 2020. The employment situation is better in rural India compared to the urban areas. To some extent, this also explains the lower level of overall economic activity.

Weakening recovery suggests that the economy needs continued policy support. However, the level of economic activity is not the only indicator that the committee would be considering. Inflation continues to remain above the target band of the central bank and, contrary to what many economists were expecting, it has not collapsed. Thus, the real interest rates have slipped into negative territory after many years. The MPC will need to discuss to what extent it intends to keep real interest rates in the negative zone, because it can affect inflation outcomes. Negative real interest rates could also force savers into asset markets like equities and real estate, which can create asset price bubbles. Further, there is plenty of liquidity sloshing in the system, which has effectively reduced the importance of the policy repo rate. The central bank would need to address this issue because liquidity may continue to rise and affect inflation outcomes.

The RBI is rightly intervening in the currency market, which has increased rupee liquidity in the system. Since the fall in imports is expected to result in a significant balance of payments surplus in the coming quarters, and continued intervention will lead to higher liquidity, it is perhaps time to limit access to international debt. Therefore, with the given financial conditions, uncertainty on the inflation front, and the fact that the RBI has provided significant accommodation in recent months, it is advisable to keep the policy rates unchanged. The MPC would do well to wait and watch how the financial and inflation conditions evolve in the near term. Another rate cut will not have a significant impact on economic activity at this stage because it is largely being constrained by the continuous spread of Covid-19.