GDP growth revival doesn’t need another rate cut--Economic Times
By Chetan Ahya
Recent data has heightened concerns on the economic outlook. GDP growth is expected to slow to a 10-year low in 2012-13 and incoming data is yet to show signs of a sustained recovery. Fiscal policy will not be able to provide counter-cyclical support to growth, given the need to consolidate the fiscal deficit.
This has led to a view that more monetary easing is needed to revive growth even as the room for further easing is limited. Proponents argue that inflation as measured by WPI or core WPI has started to decelerate, providing room for monetary easing.
However, we believe that policy rate cuts are not the panacea that markets and investors are looking for. We believe that any monetary easing should wait until there is clear evidence of meaningful moderation in inflation expectations. Taking monetary policy decisions based on the trend in WPI or core WPI as a key metric to assess the likely trend in inflation expectations can lead to inappropriate policy responses.
While WPI/core WPI has been decelerating over the last five months, CPI headline and non-food inflation have remained elevated. To the extent that the gap between price levels as measured by CPI and WPI/core WPI has been persistent and rising, we believe that WPI/core WPI inflation are not sufficient to assess the outlook for inflation expectations.
Indeed, other corroborative evidence such as weak deposit growth and high gold imports shows that inflation expectations are still sticky at elevated levels.
For growth to recover in this cycle, we need capex to pick up. Some have argued that monetary easing can help revive investment spending. However, we believe that low interest rates are not enough to kick-start capex.
Current real interest rates are still much lower than during 2004-07, when investment growth was extremely strong. Policy reforms that bolster the regulatory environment, increase legal certainty, accelerate various project approvals and create the right incentives to invest will revive confidence and investment spending.
For monetary easing to be effective, lower policy rates must translate into lower lending rates. Even if we assume that the RBI embarks on further monetary easing immediately, the rate cuts are unlikely to be transmitted into lower lending rates.
Liquidity remains tight as the creditdeposit ratio has remained elevated. The RBI has reduced policy rates by 50 bps since January, but this has yet to be translated into meaningful reduction in lending rates by banks.
Since the credit crisis, persistently high inflation expectations have led to negative real interest rates. This has adversely affected deposit growth, which is at a 10-year low. Hence, we believe that rate cuts should ideally wait until meaningful deceleration in CPI inflation and improvement in deposit growth is achieved.
The steps that the government has taken since September will help to slowly improve macro indicators such as inflation and current account deficit over the next 4-6 months. But, given the fragile macro set-up, policymakers need to remember that lower rates will act as a deterrence to improving financial saving, exacerbating the already high current account deficit (saving less investment).
Recent data has heightened concerns on the economic outlook. GDP growth is expected to slow to a 10-year low in 2012-13 and incoming data is yet to show signs of a sustained recovery. Fiscal policy will not be able to provide counter-cyclical support to growth, given the need to consolidate the fiscal deficit.
This has led to a view that more monetary easing is needed to revive growth even as the room for further easing is limited. Proponents argue that inflation as measured by WPI or core WPI has started to decelerate, providing room for monetary easing.
However, we believe that policy rate cuts are not the panacea that markets and investors are looking for. We believe that any monetary easing should wait until there is clear evidence of meaningful moderation in inflation expectations. Taking monetary policy decisions based on the trend in WPI or core WPI as a key metric to assess the likely trend in inflation expectations can lead to inappropriate policy responses.
While WPI/core WPI has been decelerating over the last five months, CPI headline and non-food inflation have remained elevated. To the extent that the gap between price levels as measured by CPI and WPI/core WPI has been persistent and rising, we believe that WPI/core WPI inflation are not sufficient to assess the outlook for inflation expectations.
Indeed, other corroborative evidence such as weak deposit growth and high gold imports shows that inflation expectations are still sticky at elevated levels.
For growth to recover in this cycle, we need capex to pick up. Some have argued that monetary easing can help revive investment spending. However, we believe that low interest rates are not enough to kick-start capex.
Current real interest rates are still much lower than during 2004-07, when investment growth was extremely strong. Policy reforms that bolster the regulatory environment, increase legal certainty, accelerate various project approvals and create the right incentives to invest will revive confidence and investment spending.
For monetary easing to be effective, lower policy rates must translate into lower lending rates. Even if we assume that the RBI embarks on further monetary easing immediately, the rate cuts are unlikely to be transmitted into lower lending rates.
Liquidity remains tight as the creditdeposit ratio has remained elevated. The RBI has reduced policy rates by 50 bps since January, but this has yet to be translated into meaningful reduction in lending rates by banks.
Since the credit crisis, persistently high inflation expectations have led to negative real interest rates. This has adversely affected deposit growth, which is at a 10-year low. Hence, we believe that rate cuts should ideally wait until meaningful deceleration in CPI inflation and improvement in deposit growth is achieved.
The steps that the government has taken since September will help to slowly improve macro indicators such as inflation and current account deficit over the next 4-6 months. But, given the fragile macro set-up, policymakers need to remember that lower rates will act as a deterrence to improving financial saving, exacerbating the already high current account deficit (saving less investment).
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