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Central Bank Must Respect Sentiment Rate cuts are not just about rational calculus

December 06, 2019 05:57 AM


Central Bank Must Respect Sentiment
Rate cuts are not just about rational calculus
The Reserve Bank of India (RBI) and the Monetary Policy Committee have disappointed by not reducing policy rates at the latest meeting of the committee. This is not because further rate cuts would have had a material impact on immediate growth prospects. It is more a question of reassuring increasingly anxious industry that those who control the levers of power and policy are concerned about the slowdown and acting to halt and reverse the trend. Q2 growth turned out to be 6.1% in nominal terms. This is less than the yield on 10-year government bonds. If incremental output is lower than the cost of investing to produce that output growth, it sends out alarm signals. Sure, for the year as a whole, nominal growth is likely to be higher than the cost of capital, but the moment was ripe for a reassuring rate cut.

RBI’s own dilemma deserves sympathy. Inflation has picked up above expectations. Further, while the policy statement carefully avoids any direct mention of it, the fiscal deficit is likely to balloon far above the official target, thanks to economic growth that is sharply below the 12% assumed for making tax projections in the Budget. In the absence of transparent communication on the size and nature of the fiscal deficit, expectations of a higher fiscal deficit are themselves likely to feed expectations of higher inflation. So, RBI has reason to be wary about cutting policy rates further, after having brought them down by a cumulative135 basis points since February. There is no paucity of systemic liquidity: on average, RBI has been a net absorber of about ₹2.4 lakh crore every day, the money market rate has been consistently below the repo rate. And the fall in the bank lending rate has been far less than the cumulative cut in the policy rate, in any case.

The significant contribution RBI has made to reviving growth is to set up a self-regulatory body to facilitate a secondary market for corporate loans. Growing the debt market is what RBI can do; as part of mending the broken financial mediation pipeline. The rest is up to fiscal and policy action by the government

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