In line with the US Federal Reserve raising interest rates by 75 basis points, the Reserve Bank of India (RBI) has just hiked rates by 50 basis points or half a percent, with the expectation widespread that others will follow. There is consensus that the RBI has little choice in the matter, but some uncertainty as to whether this is the best policy to adopt at this time.
If India’s central bank sits idle while the Fed raises rates, money could flow out of India into the United States. This will be calamitous for the Indian investment scenario and hard currency reserves.
There’s a good reason the US central bank needs to raise interest rates. U.S. unemployment rates are at their lowest since the 1970s and inflation is at their highest since 1980. So there is every reason to slow the economy down so it doesn’t overheat and then crash. collapses.
Right now, a move toward a policy-induced recession is the direction in which US policy needs to move.
In comparison, the Indian economy is also experiencing a high level of inflation. At seven percent, headline consumer price inflation is well beyond the RBI’s comfort level of six percent. But there is an essential difference with the American situation.
Headline inflation is a measure of total inflation within an economy, including commodities such as food and energy prices (e.g. oil and gas), which tend to be much more volatile and subject to spikes in inflation.
Unemployment is high in India at 7.6% and will be worse if we add in those who have completely stopped looking for a job out of disappointment.
Inflation is high for two reasons. India’s domestic energy prices have skyrocketed in step with world prices due to the war in Ukraine, with India mainly dependent on imported energy. Additionally, food prices are high due to an erratic monsoon, signaling disappointing kharif production, even as buffer stocks continue to decline.
Inflation occurs when too much money chases too few goods. In the United States, a huge amount of liquidity supports economic activity at an optimal level and it is necessary to ensure that more money does not lead to overheating and a collapse of the economy.
In India, inflation is the result of a shortage of supply – there are too few goods. If, at this stage, liquidity is reduced and companies have to pay more for financing, they will reduce their activity, which will lead to a decline in non-food production.
Simply put, what India’s economy needs is more food and cheaper energy. It also needs a higher level of economic activity for the level of unemployment to drop and for the poor to find more income opportunities in the unorganized sector.
At this point, instead of tightening liquidity by raising interest rates, the RBI should make money cheaper so businesses can borrow more and increase their level of economic activity. This will create more income primarily in the hands of unskilled workers and lead to increased private consumer spending. Hence, the demand will increase and pave the way for a high growth rate.
So what are the options in the hands of the authorities? As already stated, the RBI cannot cut interest rates even as the US Fed raises them in order to avoid an outflow of hard currencies. Also, India cannot dictate global energy prices.
However, India may encourage financial institutions to lend more by signaling that they should not raise lending rates. However, since they have to pay more to raise “loanable” funds in a rising interest rate regime, one solution for the government is to grant financial institutions some interest rate subsidy. Since public sector financial institutions account for a large share of total assets, they can benefit from the interest rate subsidy under strict official supervision.
Similarly, domestic energy prices can be controlled by allowing some subsidy. Since mass consumer products such as gasoline, diesel, and cooking gas pass through state-owned petroleum marketing companies, the subsidy element can be kept under close official scrutiny.
The combined impact of a slight subsidization of interest rates and energy prices will be to increase the budget deficit. If it exceeds budget levels, it will send its own negative signal. The good news is that currently tax revenues are quite dynamic and that the budget deficit is well under control.
As for the food situation, the government can continue programs of free and highly subsidized food distribution to the poor to avoid social distress and inflation of food prices. This will mean further cutting government buffer stocks, but it is worth the government betting on it in hopes that next year’s rabi harvest and kharif harvest will be plentiful.
This may not happen, and the situation next year may turn out to be bleak. But, it is still reasonable to hope that the war in Ukraine will be over before next year and world energy prices will fall back to pre-war levels.
What has been described above is quite heretical and will be dismissed by most economists and financial analysts, but these are exceptional times. Private consumption is still anemic and needs to be encouraged to grow so that FMCG companies continue to face healthy demand even after the holidays are over. Overall activity still needs to catch up a bit, given the current level of installed capacity.
Once companies see the prospects of continued strong demand, they will step up investment to increase capacity. This will be good news for the capital goods sector, which should already benefit from the ambitious infrastructure investment scenario presented in the budget.
The policy options outlined above should ensure that the current financial year ends with growth above 7%, despite the current gloomy mood created by the downward revision of projections by analyst firms and agencies. multilateral. But, it should be remembered that respectable growth in the current year will largely offset the slowdown created by the Covid-induced slowdown over the past two years.
The government’s objective should be to achieve an average growth of 6-7% over five years, leaving aside the Covid years. If this happens, India can hope to become a leader among middle-income countries.