Unemployment, slow growth and more: The risks of RBI’s ‘high’ real interest rates

Minutes of the last meeting of the Monetary Policy Committee (MPC) held on August 8 indicate that at least two external MPC members disagreed with the majority view and Reserve Bank of India (RBI) Dr Jayanth R Varma, Professor, Indian Institute of Management Ahmedabad (IIM-A) and Dr Ashima Goyal, Professor, Indira Gandhi Institute of Development Research (IGIDR) argue strongly against keeping rates stable, according to the Minutesand that India’s potential growth is likely to be higher.

In fact, Jayant Burma says it is 8% and that the RBI’s restrictive rate policy – ​​“high” real rates – is slowing the economy.

Dr. Goyal suggested that high real rates may create social tensions and reduce jobs. However, Governor Shaktikanta DasRepresenting the RBI’s view, the MPC says India’s economic growth is good and that gives the RBI and MPC some space to pursue inflation to the mandatory 4% target, which they both argue has remained elusive.

As this was their last meeting before their terms end in October, Goyal and Varma strongly advocated for a more cautious monetary policy, specifically calling for a reduction in the policy repo rate.

Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research (NCAER), stressed that while the projected growth rate of around 7% is promising, it is crucial to consider both supply and demand factors.

Below is a verbatim transcript of the interview.

Q: Are you arguing that restrictive policy involving a very high gap between the repo rate and current inflation, which amounts to more than 2%, perhaps 2.1%, is likely to generate social tensions and reduce employment?

Goyal: What I am saying is that we have to grow to our full potential, which is higher. We have to increase the rate of job creation to the maximum that we can, and therefore monetary policy should not reduce growth below its potential.

Q: The argument for the natural and real interest rate that was presented in the July bulletin is that the country’s potential is 7%. Therefore, it cannot be argued that we are below potential at the moment.

Goyal: No. There is a lot of controversy over the measurement of potential growth and the equilibrium real rate, and I have given some arguments why. Reserve Bank of India Some factors related to the structural growth transition we are in that would reduce the equilibrium rate have not been included. But the argument I am making is that, well, it is hard to agree with the estimate, but just look at the result. If core trend inflation is falling, it is 3% below the target, which means we are not at potential. We can grow faster without increasing inflation.

Q: I understand your point that core inflation is one parameter that indicates that growth may not be very good. But if you look at many other parameters, including the purchasing managers’ index (PMI), Gross domestic product (GDP) The figures available up to the last quarter paint a slightly different picture. Dr. Varma, you argue that the general idea of ​​a potential growth of 7% is wrong and underestimated.

Varma: Of course, because we are at a stage in our economic growth where we need to grow much faster and we have the capacity to do so. We have to recognize that we are at a stage, in the demographic cycle, where a large number of young people are entering the workforce every year, and this demographic benefit to us will last for another decade or more.

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At this point where so many people are entering the workforce, it is possible to grow in a non-inflationary manner at much higher rates, because there is that ready-made workforce to be absorbed, and jobs can be created without putting upward pressure on wages and input costs, etc.

And the other obstacle to rapid growth would have been issues like infrastructure, etc., which, I repeat, the reforms of the last few years have largely addressed; we have made significant investments in public infrastructure; all this means that the economy is capable of growing much faster. It needs to grow much faster.

And I think the right benchmark is now to look at how other economies are growing today. Today, most of the big economies are well past their demographic transition. China’s population is declining. We have to ask how fast those economies were growing when they were at the same stage of our demographic cycle. When their labor force was growing, how fast was it growing? China was growing at a rate of 11-12%. That’s the growth rate that an economy is able to achieve when there’s a flood of new workers entering the labor force and you don’t have to pay higher wages to absorb that influx.

That is the kind of horizon we should have, that double-digit growth is what we should aim for. And even if we think that would require further reforms, even the reforms that have already been made should be able to take us to 8.

Q: This is an argument that is made again and again, and the economic survey does not support it. In fact, V. Anantha Nageswaran, chief economic adviser to the Government of India, repeatedly says that we are not in the global situation that China was in in the early 1990s. I want to ask you a few other questions on monetary policy. But first, Dr. Bhide, your general macroeconomic assessment is that growth is quite strong, so why meddle with it? Let us focus on the mandate. Is that the general thesis?

Fur: Yes, growth rates of around 7% were also forecast at this meeting and I think it is important that on the supply side we see those bright spots, which are opportunities to increase the growth rate. But I think we should also be concerned about the immediate demand situation. And I think the growth that has occurred in the last year and probably the projections for the current year also take into account the growth prospects for investment and consumption.

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And it’s important to recognize that in both projections, there are risks associated with that. So it’s not just the supply side that matters when looking at the growth rate. In that context, a 7% growth rate seems to be pretty strong growth right now. So if we need to raise this growth from 7% to 8%, I don’t think current demand conditions support that.

Q: Dr Varma, coming back to your question about this real interest rate which is almost as high as 2.1 because the one-year forward inflation, which the RBI has forecast is 4.4, the current interest rate is 6.5, so it is effectively a real interest rate of 2.1, which you argue is too restrictive. But when you look at the financial conditions, and even when we talk to corporate heads, nobody is complaining about any restriction. Look at how the stock markets are going wild. Look at the amount of money going into F&O, people seem to have too much money. The RBI is rightly concerned about unsecured loans getting too much attention from banks and therefore asset quality going down. All this does not show restrictive monetary policy conditions, does it?

Varma: Asset markets have their own logic and monetary policy cannot depend on them. Asset markets are influenced by global factors and at the moment there is a global risk appetite that is driving asset prices in several countries.

Now, that doesn’t tell us anything about whether monetary policy is restrictive or not. The question we need to ask is what is happening to private sector capital spending.

If the situation is bullish, why is private sector capex not happening? For the last one year, it has always been thought that private sector capex would happen next quarter. It is still on the horizon and we have been waiting for four quarters, six quarters and it has not happened.

And at some point, as I said in my statement, hope is not a strategy. You can’t just keep hoping that capital spending will pick up. You might ask, yes, what are the conditions required for that capital spending to happen? And the condition required for that capital spending to happen is that the demand has to be there and be sufficiently attractive. And a very high real rate makes capital spending unattractive for businesses. And if demand is inadequate, that also happens, and tight monetary policy is one of the factors driving demand as well.

When the EMI increases, every rupee that the EMI increases is one rupee less available for consumption. And if we think that demand is efficient, that the economy requires a lot of fiscal support because private consumption expenditure is not growing, then we have to ask ourselves what we have done. Is monetary policy part of the problem? And I think at some point we have to ask ourselves whether monetary policy is too restrictive. Is it too restrictive at a time when inflation is so close to the target?

I wouldn’t ask this question if inflation was at 5.5%. But when inflation is so close to target, you have to ask how much growth sacrifice are we willing to pay to accelerate those last 40 basis points (bps) of decline. That was the question. There’s no doubt about the destination we have to reach for that, but the question is: what price are we willing to pay to do it a quarter earlier than before?

Watch the attached video to learn more.