The political risks of low interest rates are high in an election year

Since 1989, governments have risked that the benefits of higher economic growth will offset the costs of higher inflation

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) got it wrong last week in telling the RBI not to fiddle with the repo rate, which determines the price of money in the economy, commonly known as the interest rate. 

What will be the consequences of the decision of not raising interest rates for the ruling party? How many seats will this cost the BJP?

The recommendation means that banks can now access money from the RBI more cheaply than otherwise -- the variable reverse repo rope trick notwithstanding. This means they can also lend more cheaply. It also means there is a bigger risk of higher inflation because output, while rising, could rise more slowly than demand, especially for food.

Economists, of course, have invented a range for ‘good’ inflation -- between 2 per cent and 6 per cent. 

But here’s the thing: the inflation number for the economy as a whole is actually quite a meaningless number. It’s what statisticians call a weighted average where the ‘weights’ indicate the importance of various categories of things. The more important the category, the higher is its weight. 

Thus, food in India has an overall weight of 47 per cent. I don’t know why it’s not 45 or 50 or even 60 per cent; it should be, where there are hundreds of millions of poor people. 

Still, 47 is very high. But is it high enough? People who earn more than Rs 12 lakh a year don’t really know. But the daily wages guys do, as do millions of families that earn less than Rs 12 lakh a year. 

The political impact

Remember: of the past seven general elections, overall inflation of 10 per cent or more overall -- and 20-odd per cent for food -- has been a very major factor in four of them. If the general election of 1999 is excluded, which was won by the BJP on the back of the Kargil war, it means inflation has been a factor in four out of six elections.  

The politicians know this. Governments know this. They know that if the sarkari rate is X, the real effective inflation rate is 2X. (I have just invented a new term — REIR, like REER or real effective exchange rate. More about this in another article soon). 

Political risk notwithstanding, since 1989, governments have opted to risk it, in the hope that the benefits of higher economic growth will offset the costs of higher inflation. And, you know what: in 2009, the bet had indeed paid off. In spite of 10 per cent inflation during the latter half of 2007 and all of 2008, the Congress increased its seats from 145 to 208. Its vote share also went up. The reason: output and jobs were rising at nearly the same rate. 

So it tried the same strategy in 2014 -- and lost all but 44 seats. Reason: food prices had gone up by 65 per cent between 2010 and 2013. 

In contrast, between 2014 and 2019, the BJP kept food inflation at less than 5 per cent and, despite falling incomes. It won 303 seats in 2019, up from 275 in 2014. 

Look at more evidence. In 1995, the overall inflation rate was more than 10 per cent. Food inflation was by definition much higher. The Congress lost the election. 

The same thing had happened in 1989. The Congress lost 217 seats, down from 414 in 1984.  

Thus, Rajiv Gandhi in 1986-89, Narasimha Rao in 1994-96 and Manmohan Singh in 2011-2013 had all bet on growth despite the high inflation. All lost the general elections. 

The question now is if Narendra Modi will have the Manmohan experience of 2009 or of 2014.