Expert Zone

Straight from the Specialists

Is higher growth possible with higher interest rate?

July 21, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Last time it was really hefty. The RBI administered a double dose of 0.5 percent when on the previous nine occasions it was content with half that hike. What prompted the RBI was the reluctance on the part of inflation to move down — the central bank had thought it could be engineered with a higher dose.

That also did not work. On the contrary, inflation moved a step up to 9.4 percent and expectedly industrial growth moved a step down to 5.6 percent. The latter, however, does not seem to be a concern with RBI though it certainly is with the finance ministry.

The RBI would like inflation down and industrial growth up. But the two generally do not go together and therefore pose a choice. The RBI prefers lower inflation even if it means lower growth. That is because price stability is its mandate.

It is not that in public policy inflation has low priority. It is whether the rate increase is the way to temper inflation. Monetary policy is the only option with the RBI. It is the other measures, however, which are more relevant and can be more effective. These are the responsibility of the government.

Even if the interest hike did not have an impact on inflation it had to be manoeuvred to correct other imbalances that arise. The more obvious reason is that inflation forces the lender to subsidise the borrower. This can cause serious imbalance between savings and investment and accelerate inflation. Therefore the best that can be expected from the RBI in its next round of policy review is a pause in interest hike. More likely it can be its normalised 0.25 percent increase in repo rate.

Does that mean that growth will have to be compromised? Not necessarily. The present inflation is not due to over-heating of the economy but a shortfall in agricultural production. That is why food inflation soared up too high in comparison with inflation in the manufacturing sector. Since a higher rate of interest hits investment activity, it is important that fiscal means are introduced to make up for the higher interest rate.

To keep up growth, investment should be kept going and for that investment should be as profitable as it was before the rate increase. The best way of doing that is to introduce for a limited period investment allowance which was in vogue in the seventies and eighties.  All it implies is weighted depreciation with no loss of revenue for the present. It will provide a stimulus to investment and restore profitability.

It is expected that the monsoon will make some difference to inflation. Even if it does, it will be quite some time before a reversal of interest rate comes through. By then investment will drop and growth will slow down and may take another year to pick up again. Hence if the monetary measures are supplemented by fiscal incentives a higher growth would be possible even with higher interest rate.

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  • Editors & Key Contributors