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Last Updated : Jul 12, 2016 03:09 PM IST | Source: Moneycontrol.com

Why FM may be wrong in his call for lower deposit rates

In a recent speech, Finance Minister Arun Jaitley called for lower deposit rates in the economy, saying high interest rates on savings instruments translate into higher cost of lending and lead to sluggishness in the economy.

In a recent speech, Finance Minister Arun Jaitley called for lower deposit rates in the economy, saying high interest rates on savings instruments translate into higher cost of lending and lead to sluggishness in the economy.

At some levels, the argument makes sense. The monetary system works in a reinforcing-loop mechanism.

When the Reserve Bank decides on an appropriate benchmark interest rate (called the repo rate), banks set their own deposit rates around it, and when this plays into their cost of funds, they adjust their lending rates appropriately. Thus lower deposit rates will likely ease to lower cost of funds, which generally spurs economic activity.

However, in his call for lower deposit rates -- a key driver for which is obviously the central bank's repo rate -- the Finance Minister chose to ignore two key elements that also come into play when it comes to monetary policy decisions.

First, Jaitley chose to pass over inflation. Fast-growing emerging economies such as India are almost always struggling with high inflation. This is because while high growth puts pressure on prices on the demand side, a number of factors contribute to supply side pressures as well (lack of infrastructure, slow growth in agricultural yields, etc). India in particular has battled a chronic inflation problem.

While some economists argue, with merit, that there is little correlation between the benchmark interest rate and inflation -- after all, high interest rates will have no little to no effect on supply side inflation (high food prices driven by shortages) -- it is certainly one of the levers that can control the demand side inflation.

And while high interest rates not only help in taming high prices to an extent, they also compensate for savers by providing them a decent rate of return during times of high inflation.

Given the lack of a sound social security net in India as opposed to that in the West, it is incumbent upon the government to look after the needs of retirees and savers.

It also important to note that interest rates need to be seen in the context of real rates: for instance, a nominal interest rate of 5 percent and inflation of 10 percent would real rates of -5 percent. (In such an environment, savers are harshly penalised as their returns are below the rate of inflation, resulting in reduced standard of living). Conversely, if the rate of interest is higher than inflation, it results in positive real returns -- as is the case now.

During a recent speech, outgoing RBI chief Raghuram Rajan, known for his anti-inflationary stance, eloquently argued the third problem with allowing interest rates to fall at the cost of losing control on inflation.

"In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation," he said.

"Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits. This meant that India needed to borrow from abroad to fund investment, which led to a growing unsustainable current account deficit."

Simply put, a high inflation environment actually leads to higher cost of funding.

Having said that, there continues to be a lag in monetary policy. That is, after an appropriate policy rate has been set, the rates in the market take time to catch up.

Towards this, both the government and RBI have taken, and will do well to take more, steps to reduce the transmission lag.

Some of these include changing the way banks calculate their marginal cost of funds and linking the returns of savings instruments such as PPF to the market rate.
First Published on Jul 12, 2016 02:18 pm
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