Monday, September 3, 2012

Interest Rate, Inflation and the Growth Conundrum..!

The Economic Times of 30th August carried three interesting and related reports.  First one was about a speech that the RBI Governor, Dr. Subba Rao, delivered at Cornell University, where he stated that RBI was not planning to reduce policy rates owing to high levels of inflation.  He said that unless inflation reaches an acceptable level of 5% or below, there is no scope for a rate cut.  The second story dealt with the opinion of Mr. K V Kamath, the chairman of the second largest bank of the country.  He argued in favour of a rate cut by RBI by 1% points to spur economic growth.  He said that keeping rates high may not be doing anything to contain inflation.  However, whether a reduction in rate would propel growth, is something that even Kamath says is worth experimenting!  The third one was a column by Prof. T T Ram Mohan of IIMA, where he says that RBI can not be blamed for the economic slowdown.  Based on the recent statistics, he argues that increase in interest rates and global slowdown can explain only a portion of the economic downturn.  He says, it is not the interest rate than can boost growth, but positive policy measures and public investment in sectors like infrastructure.  It was a pleasure reading these three pieces together, as each one represented a specific angle - a regulator, a banker cum businessman and an academician.

Let me quote few lines from the latest RBI Annual Report: '...even at the current level of the policy rate, the real effective lending rates of the banks are relatively lower in comparison with their pre-crisis levels.  This highlights the fact that policy rate alone cannot explain the sharp growth slowdown.....'.

In a global scenario marred by recession, the only hope for growth is from domestic demand.  If the interest rates are reduced, two simultaneous forces should work in the economy in order to propel growth.  First, with reduced interest rates, people should reduce savings and increase consumption.  Second, in order to meet the increased consumption needs, the business sector should increase their output by borrowing money from the market at lower interest rates and investing it in productive activities.  Here is the catch: what is the guarantee that reduced interest rates would enhance demand?  Another trend that is revealed by the RBI data is that household savings have started drifting more towards physical assets like gold and real estate, which people consider as safe bet during times of high inflation.  But these investments are unproductive in nature and do not help in capital formation.  If this is the case (even with high interest rates), one wonders whether a marginal reduction in rates by RBI would have any impact on growth at all.  In a way, we are continuing with the age-old debate in economics between Keynesians and Monetarists.  Let the debate continue.


2 comments:

  1. I definitely agree with you sir...Thank you for sharing this.

    However with increased consumption which inturn increases the demand, the manufacturing/business sector should be selling at a lower price (applying economies of scale) than before. Assuming income as constant, even with increased consumption, a consumer might end up spending the same amount. In that case the companies should think of products and services which are innovative and premium so as to actually influence and owe the consumers.

    your thoughts sir?

    murali

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  2. Taking a Quote from our PM's speech " Inflation is the sign of growth " No doubt on that. As the percapita income increases people tend to spend more and more. But in the current scenario the inflation is purely due to supply - demand mismatch(Consider the food inflation ). But I do not think the old theory of increasing interest rate is the only measure to check inflation. It may be true for some sectors like auto,infrastructure and whitegood. but increasing the interest rate affect the common man alot.There should be some policy measures to increase the supply and become self sufficient. As the fuel price is the main drive of inflation in India,Its high time we nationalise our energy base instead of giving it to reliance ,Cairn and BP. There should be effective utilisation of resources (Like farm land) to acquire food safety.

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