RBI Rates Cuts and Their Importance

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    In October first week, a new Monetary Policy Committee (MPC) decided at its first policy review to reduce the benchmark repurchase rate by 25 basis points to 6.25 per cent. What is its importance and what should be expected?

    The Reserve Bank of India’s key policy interest rate has now been cut to its lowest level since 2011.
    The unanimous decision of MPC is said to be in consonance with the objective of achieving consumer price index inflation at 5% by Q4 of 2016-17.
    The retail inflation had already dropped to 5.05% in August. The wholesale inflation also reduced to 3.57% for September.
    The RBI Governor clarified that the central bank aims to achieve the 4% inflation target within a range of +/- 2 per cent as the medium term objective by 2021. This means that the earlier objective of taming inflation to 4% level by March 2018 stands null and void.

    Importance
    The RBI rate cut performs the very important task of ‘signalling’.
    Despite the high growth rate of 7.5% that the Indian economy seems to be registering over the past two years — this is the highest rate among the major economies of the world. Particularly, the performance of Indian industry in general, and manufacturing in particular, continues to be far from satisfactory.
    Thus, the impact of policy change is necessary to be assessed.
    The rate cut of 25 basis points is not expected to bring about a dramatic change in the investment climate. It has to be supported by many other important factors to be operating favourably and in tandem. Two of these are:

    The Keynesian ‘animal spirits’– it calls for the investors to have a substantial measure of spontaneous optimism about their projected line of activity. Currently, this optimism seems to be lacking.
    Keynesian ‘animal spirits’ is used to describe human emotions and instincts that influence and guide human behaviour which can be measure through ‘consumer confidence’.

    There is need of administrative and bureaucratic environment which facilitates and encourages investment activity. 2016 marks 25 years of economic liberalisation but despite the plethora of reforms that have been undertaken in the spheres of industry and commerce, India presents a picture of a country that is still rule bound.
    There is no doubt that constant measures are being taken by government of India in terms of ‘ease of doing business’ and there has been improvement in index in the past year. This has to be a motivating factor for the potential investors.

    Thus, the rate cut offers a signal or a directional indicator suggesting that the central bank is interested in maintaining the growth momentum.
    This is important particularly against a background where the RBI in recent times had been substantially identified with pursuing an inflation targeting approach, to the exclusion of all other contending objectives.
    Two key factors seem to have contributed to the rationale for the rate cut

    The RBI is now guided by retail inflation in deciding its monetary actions. So, with the fall in retail inflation in August to 5.05%, the RBI was confident of reducing the repo rates.
    More importantly, there is expectation of decline in food prices due to good monsoons in past Kharif season. This will further soften the food articles inflation, especially pulses and vegetables.

    The world economy is witnessing generalised weak investment and trade activity. This has been worsened by sharpening of inequality across most major economies of the world.
    The consequence of this is a suppression of aggregate demand.
    Thus, the decision of MPC comes in the background of such global deceleration scenario in 2016.
    However, amidst this condition, India presents a contrasting picture where the overall growth rate seems to be reasonably satisfactory, with the possibility of a good agricultural performance, which would boost rural demand.
    Thus, the rate cut seems justified.
    However, much of the success of rate cut now will depend on how it will be transmitted to the final users via the banking system.

    Virtually banking are confronting the problem of excessively large volume of non-performing assets (NPAs). It is known that this problem has not risen overnight and the major defaulters have been from among the top business houses in the country.
    The problem has been rooted in crony capitalism where many questionable deals are pertaining to political party in power.
    Thus, dealing with this problem requires a great deal of firm actions and decisions and pragmatism along with systemic change in the nature of the political economy that has been practised so far.
    Source  : IAS BABA

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