The Governor's gambit: A double order of a big beautiful cut

Time of India

3 hours ago

Firing a half-percent
rate cut
off the hip, the new Governor of RBI has signalled that he is not there for half measures. One is reminded of the wisecrack of the street-smart gunslinger immortalised by Eli Wallach in the Good Bad and the Ugly: 'if you want to shoot, shoot, don't talk' though, after firing the double barrel, the Governor also talked for good measure, declaring that one should not equate the projected growth rate with the desired goal and the real goal should be to achieve 8% growth on a sustainable basis! That is a big statement coming from the head of an institution whose one big KRA is inflation management.
As if all this was not enough, there was a 1%
CRR cut
spread across the year to ensure ample liquidity in the market to drive growth. As @SugataGhosh observed sagely in his Economic Times column, only a governor not weighed down by a doctorate in economics could have trodden with such decisiveness in a field where standard operating procedures demand tiptoeing.
Among other things, the Governor's gambit opens up an opportunity to undertake a critical review of the conventional, calibrated approach to interest rate adjustments.
by Taboola
by Taboola
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Interest rates is an old, oft used tool used by central bankers to manage inflation, but honestly its track record in inflation management has been rather chequered. Arguably, this is because interest rates have two divergent effects on inflation and neither are first-order effects. On one side, a high interest rate will increase the financing costs of businesses who borrow money. This extra cost would eventually find its way into the consumer prices, adding inflationary pressures, though after a lag. At the same time, higher borrowing costs will also slow down the demand for new assets such as homes and cars and investments in new factories, which will cause a general slow-down in demand and thereby moderate inflation through second-order effects.
There is a further twist: the relationship between demand and cost of finance is not linear or straightforward; the future inflation expectation of the market has a big role in equation. Change in demand can be viewed as a function of the difference between the present borrowing costs and future inflation expectations.
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To use an example, assume the home loan rates have been hiked to, say, 9% from 8.75%. It will have an impact on home demand only if the markets (the collective psyche of the home buyers & sellers) believe that home prices will rise by less than 9% annually henceforth. If buyers believe that home prices will raise by 10% in future, the 9% interest rate will become a mere irritant for the buyers without changing their behaviour.
Similarly, if sellers believe the prices will rise by 10%, they will not be too fazed by the 9% financing costs as to offer a price discount. So the interest rate hike (or cut) will work only if it can modify the future inflation outlook of the market.
So, the real intent of the interest rate shift is to signal to the collective psyche of the consumers and sellers that Central Bank wants to slow down or speed up things a bit, thereby nudging them to revise their earlier inflation expectations. It is sort of a mind-game, at times it works, at times it doesn't, but a largish one-time rate-shift is much more likely to get people's attention than multiple small changes spread across a number of quarters.
No doubts, the ride will be much jerkier under this method compared to the slow, leisurely shifting of gears the markets are accustomed to, but that is exactly the idea. The change should be material enough shake up things a bit so that people will be forced reassess their inflation projections. In short, to be effective, rate changes have to be administered in larger doses within a shorter span.
Further, because interest rates influence growth through second order effects, there will always be a lag in transmission and some translation losses as well, both of which can be reduced by front-loading the anticipated changes.
The worst-case scenario is that a cut or hike may have to be rolled back partially at a later date. That may sound like an awkward idea at first, but the awkwardness will ease if we can get used to the idea that central bankers are not all-knowing savants, but just a group of learnt heads trying to connect the dots before they have appeared on the screen.
Of course, the bond traders and other market intermediaries may certainly frown upon this approach, they hate to be caught on the wrong side of the interest rate curve and hence passionately argue for predictability and smoothness in the rate-shift manoeuvres. While their concerns may not be without merit, the regulator's primary attention should be on achieving the desired effects on the market rather than easing the collateral side-effects on the market-makers. Besides, there may be even a way to balance both the sides as RBI themselves have shown in the CRR reduction approach.
Perhaps next time RBI can announce a 75 percent rate cut or hike upfront to be rolled out over a 6 months period. This will also obviate the need for RBI to disclose their policy stance as accommodative, neutral, hawkish, dovish etc. The stance will become embedded in the rate and hence implicit.
On the flip side, it will take away some speculative joy from the market players' lives who try to read the central bank's mind and punt on it, a small sacrifice for a good cause.