RBI study warns against rate cut to stimulate growth

Researchers at the Reserve Bank of India (RBI) have delivered a stark warning against lowering interest rates in a bid to stimulate growth.

India has experienced – by its own standards – lacklustre growth since 2010, as annual GDP growth has gradually declined from 9.4%. In its latest quarterly review of monetary policy, published in July, the RBI lowered its growth forecast for 2013 from 5.7% to 5.5%.

When Raghuram Rajan takes over as governor of the RBI, on September 5, he will have to find a policy balance that avoids suffocating economic activity while ensuring the recent decline in inflation is not reversed.

One study, published by the RBI yesterday, warns against cutting the central bank's nominal interest rate in a bid to stimulate either growth or investment.

The study, written by members of the RBI's monetary policy, statistics, and economic policy and research departments, says the cut would do more harm than good, as any growth benefits would dwarfed by the costs inherent in higher inflation.

Real vs. nominal

The authors argue that the real interest rate – more than the nominal – matters most in economic decisions relating to investment, consumption and saving. The central bank's nominal interest rate, therefore, may not always "reflect the correct stance of monetary policy".

In 2011, the RBI hiked its key rate by 200 basis points between March and November, but in the markets real lending rates subsequently fell "lower than the levels seen during the high growth phase before the global crisis".

The authors suggest that although the RBI raised rates it was not an "aggressive response" to the high level of inflation – which at the time was above 9%, and contributing to lowering the real interest rates.

Despite lowering the real rates, however, growth and investment both declined, which the study attributes to a fall in the marginal productivity of capital.

Given this situation, the authors said, one way for the central bank to stimulate growth would be to double down and depress real rates even further. The most direct way of doing this would be to explicitly raise their inflation tolerance, and lower their own nominal rate even when inflation, or inflation expectations, remain high.

This, the authors insist, would be a mistake, as the beneficial impact of lower real rates on growth is "more than offset" by the damaging effects of higher inflation, "particularly when it exceeds a threshold level of 6%".

Stronger institutions

Rajan spelled out his views on why Indian growth had slowed, and how to fix it, in an online post for the Project Syndicate website in April.

India, he said, was "not fully prepared" for the rapid growth it experienced prior to the financial crisis, principally as a result of the conflicts over land ownership between farmer or trial groups and developers. "In short, strong growth tests economic institutions' capacity to cope, and India's were found lacking," he said.

At this point, with institutions struggling to allocate the country's resources efficiently, the political checks and balances kicked in, he explained, creating barriers to investment and slowing growth further.

These problems were compounded by the global financial crisis, when demand from industrial countries began to dry up. The Indian authorities responded by boosting domestic demand, but this backfired somewhat, as the goods that were locally demanded were in short supply. This resulted in asset-price booms and inflation.

Rajan believes that to boost growth in the short run, India will need to reverse this process by shifting away from consumption and back towards investment.

"It must do so by creating new, transparent institutions and processes, which would limit adverse political reaction," he said. "Over the medium term, it must take an axe to the thicket of unwieldy regulations that make businesses so dependent on an agile and co-operative bureaucracy."