Time for more action
The weekly inflation numbers continue to confirm that the macro-economic situation has changed, and done so dramatically. This should give policy-makers the elbow room to ratchet up their responses to slowing growth without worrying about provoking an inflationary spiral. Rapidly declining oil prices are, of course, the most significant contributor to the decline in inflation, but it is also being helped along by sharp falls in the prices of other important commodities as well as falling capacity utilisation and attempts by producers to bring down their mounting inventories. The decline in tax collections in December underlines what other economic indicators have already pointed to.
As far as central banks around the world are concerned, there are significant differences in their capacity to use traditional instruments in combating the slowdown. The US Federal Reserve and the Bank of Japan have effectively brought down their respective policy rates to zero and will have to rely on other means to put fizz into their economies. But others, like the Reserve Bank of India and the People’s Bank of China, still maintain relatively high benchmark rates, 6.5 per cent and 5.3 per cent respectively, and the falling inflation numbers certainly provide strong enough reason for them to make further cuts in short order. The danger of capital outflows is not there because rates overseas have fallen already. In India, the compulsion is particularly strong, since the electoral schedule precludes the presentation of a full Budget for the fiscal year 2009-10 until July 2009. This limits the room for a fiscal response, therefore putting all the weight on monetary policy. It follows that the Reserve Bank must act as soon as possible to reduce further the repo rate, the reverse repo rate and the cash reserve ratio.
It is important to point out, though, that while these measures are necessary, they will not be sufficient. Monetary stimuli will only work when the financial system begins making more funds available at lower costs to companies and consumers. That this has not happened so far is indicated by the sharp decline in the yields on the benchmark 10-year government securities. In recent days, this yield has dropped below the repo rate of 6.5 per cent and appears to be rapidly converging to the reverse repo rate of 5 per cent. This means that banks are reaching a point where all their excess funds are either being parked in the reverse repo window or being invested in government securities. Despite several announcements by banks about lower interest rates, including the highly publicised rates for small housing loans, the yield trend provides strong evidence that these remain on paper. This reluctance to lend must be addressed along with the more traditional reductions in rates. Otherwise, a cut in the reverse repo rate could simply translate into even lower yields on government securities. A variety of measures is required, including accounting changes that limit the ability of banks to declare their capital gains from falling yields as profit. Many of these measures will, of course, have important long-term implications, for which responses need to be worked out down the line. But, for the moment, the priority must be to use whatever means are available to get money into borrowers’ hands and have them spend it.