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How inflation targeting affects us - Outside View by S.S. TARAPORE
 
 
How inflation targeting affects us

It has been repeated ad nauseam that inflation hurts the weakest sections the most. For many years, India was a country with one of the lowest inflation rates among the Emerging Market Economies (EME). Unfortunately, in more recent years, we have the dubious distinction of being one of the EMEs with the highest inflation rate. Protagonists of high growth argue that if we want a higher level of employment, we have to tolerate a higher inflation rate.

Inflation targeting has been discussed in India for the past twenty years, but the view that prevailed was that India, with its complexities, is not suited to a regime of inflation targeting. This is unfortunate, as the ground reality is that India has been through a prolonged period of high inflation with the attendant misery for the lower income groups.

In this context, the accord between the Government of India and the Reserve Bank of India (RBI) in terms of the Agreement on Monetary Policy Framework (February 20, 2015) is a historical watershed in Indian macroeconomic policy. The objective is to move to an inflation target of four per cent+/- 2 per cent. The RBI prefers a gradual, non-disruptive deflationary path and the eventual objective would be to reach the mid-point of the range (2 per cent to 6 per cent) i.e. 4 per cent. The alternative of a 'cold turkey' approach i.e. bringing about a sharp and sudden reduction in inflation by undertaking very harsh measures, would put pressure on the authorities to back off and ease monetary-fiscal policies, which would result in the economy going back to square one i.e. high inflation rates.

Impact of April 7, 2015 measures

While the RBI, on April 7, 2015, refrained from further easing of policy repo rates, the banks were ticked off for not allowing the transmission of the earlier two repo rate cuts, each of 0.25 per cent. Following strong suasion by the RBI, the leading banks dropped both deposit and lending rates. A question that arises is how far will the rate cuts cycle go? Governor Rajan has referred to a 1.5-2.0 per cent real rate of interest as being appropriate; the real rate being the nominal interest rate minus the inflation rate.

The issue of real rates of interest raises a host of questions. Is the real rate of interest to apply to the banks' Base Lending Rate or the one year term-deposit rate? One fervently hopes that the real rate of interest of 1.5-2.0 per cent would apply to deposit rates. With an inflation rate at the mid-point of the range i.e. 4 per cent, the term-deposit rate would be 5.5-6.0 per cent, which would be substantially lower than the present term deposit rate.

There is a need to tread very carefully and a cast-in-stone formula may not be desirable. First, even if a 1.5-2.0 per cent real rate of interest is considered appropriate for the industrial countries, considering the capital-labour natural factor endowments in India, it may be better to work with a real rate of interest of say 3 per cent (Dr. C. Rangarajan, the doyen economist, has suggested this rate). Second, with the sharp swings in the inflation rate, it would be best to use an average inflation rate over a period of time. Third, it is necessary to take into account reserve requirements which are very high as compared with much lower or nil requirements in the industrial countries. Fourth, in India the net interest margins (NIM) have been in the 3-4 per cent range. While the NIM in India appears higher than many industrial countries, in the US, the NIM is over 3 per cent. Fifth, it would be preferable to give careful thought to the determination of the interest rate structure based on average rather than the marginal cost of funds and return on funds.

More importantly, given the central role of household sector savings in gross domestic savings in India, and the predominance of bank deposits in household sector savings, great care needs to be taken while determining the appropriate real rate of interest on term deposits. Given the relative bargaining power of depositors and borrowers, there is a danger of nominal term deposit rates falling precipitously to a level where depositors are pushed to imprudent risks while distributing their savings between different assets.

Where should household savers go?

Household sector savers will, in the coming years, need to brace up to lower bank term-deposit rates. There would be a process of conjectural variation wherein bank borrowers, depositors and banks size up each other's responses to changes in interest rates.

First, bank depositors should carefully move from bank deposits to company deposits. Savers should not invest in company deposits offering very high rates and they should put a premium on safety. Second, with lower housing finance lending rates, savers should make a beeline to investment in housing. As a rule of thumb, the equated monthly installment (EMI) should not be higher than say 25 per cent of income. Third, long-term savers should put in 10-15 per cent of their savings in gold schemes such as Gold Bonds, Gold Deposits and Gold Exchange Traded Funds. While this is contrary to advice earlier given to savers not to exceed 5-10 per cent of their savings in gold, as gold prices are at present moderate in the recent period, a higher proportion in gold would be feasible.

Savers may need to move into the equity market. Those who are unfamiliar with the equity market would be best advised to invest in mutual funds, provident funds and pension funds, for say 10-15 per cent of their savings. An exodus of bank term-deposits will force the authorities to back off from excessively reducing interest rates. Deposit holders are not as helpless as they are made out to be.

Note: This article was first published in The Freepress Journal on April 20, 2015. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.

Disclaimer:
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