The dark side of low interest rates

“We should wonder whether lower and lower interest rates are in fact part of the problem …” 
—Raghuram G Rajan, Frankfurt, 2013 

The Reserve Bank of India (RBI) did not make any cut in interest rates in its announcement on October 9. However, the fact remains that the inflation-adjusted repo rate in India is currently anyway minus 3.34 per cent, which is less than the corresponding rates in the US, Europe and Japan. It is true that the inflation-adjusted rates for borrowers in the market are not that low but they are low enough. The low interest rate policy may be popular but there is a dark side to it. The interest rate policy is “very, very blunt”. 

Low interest rates (and related concessions) are supposed to push spending and investment. But it is, as John Maynard Keynes had emphasised, doubtful if this policy works in a recession/crisis. Whether or not low interest rates push spending and investment, they certainly imply low interest income for pensioners, charitable trusts, widows, middle class people with savings, local public bodies, non-governmental organisations, endowment funds in educational/research institutions, and so on. 

The RBI is supposed to target 4 per cent inflation rate with a leeway of 2 per cent around that target. However, for a year now, inflation has been above 4 per cent and for many months, it has been above the upper limit of 6 per cent. It touched 7.34 per cent in September. So, the high inflation is hardly transient. It may be argued that high inflation can be good for output and employment. However, public authorities have already debated the reliability of that argument over the period 2013-16 before inflation targeting was adopted. So, it is not advisable to invoke that argument again — at least not at this stage. Then, why the high inflation? 

It is doubtful if supply side issues have been serious and persistent enough to warrant the high inflation observed for a year now. Notably, the reserve money has expanded by 13.9 per cent for the year ending October 9, 2020. This is very high, given all the slowdown in general and the Covid-19 situation in particular. This suggests that the high inflation is also, if not primarily, a monetary phenomenon related to the low interest rate policy. 

It is true that we have had the problem of a huge dollar inflow; the RBI tackled this by buying more than $50 billion and in the process issuing more base money. However, that problem could have been handled differently. But it was not. The RBI apparently wanted to issue more money to maintain low interest rates. 

While the low interest rate policy may or may not help with investment, output and employment, it can aggravate, if not cause, financial instability. With the low interest rates and participation of “Robinhood investors”, there has been an upward movement in prices of stocks in general and “growth stocks” in particular. As and when the interest rates rise to more normal levels in future, we can have a fall in stock prices. So, we can have a rise and then also a fall in stock prices over time — thanks to the interest rate policy. Neither fundamentals nor sentiment are involved! 

It is one thing to maintain credit flows in a recession, it is another to keep interest rates low. We do need the first but not so much the second. What is happening is somewhat the opposite. Also, it is one thing to lower interest rates for borrowers through a reduction in the big interest margin that banks keep in India and another to lower interest rates through the RBI. We are focussing too much on the latter and not worrying adequately about the former. It is time to rethink. 

Is it all the doing of central banks? It is true that there is in any case, in a broader perspective, a long-term worldwide trend of falling real interest rates in the market, and currently even the estimated neutral rate of interest is low. However, these outcomes are not independent of the policy framework. So, broadly speaking, low interest rates are indeed related to policy. 

The ratio of public debt to GDP is likely to touch 90 per cent in India; the ratio of public debt to total government receipts is well above 500 per cent. For debt servicing, it helps to have low interest rates. It is hoped that the government does not develop, what may be called, a vested interest in low interest rate policy. 

There is a world of policies once we start thinking outside of the low interest rate option. It is time we took a hard look elsewhere —never mind what the developed countries are doing.

The writer is visiting  faculty, Indian Statistical Institute, Delhi Centre