The latest news on growth and inflation should be the most worrying one for policymakers. The asymmetry between growth and inflation is becoming very obvious.

Though it has been empirically tested from time to time and it has been found that there is a cointegration between the two variables, the adjustments between the two in expansionary and contractionary phases do not seem to be of identical speed and size any longer.

During the expansionary phase of an economy, the so called “animal spirits” give rise to higher demand for resources and given the supply in the short run, credit growth and price level and hence interest rates should all be “upward moving”. And in the downward phase they should be “downward moving”.

This phenomenon, known as the pro-cyclical nature of interest or credit growth is increasingly becoming uncertain, much like the monsoon.

Increasing uncertainties

Changes in economic growth and credit growth and changes in price level are no longer seen operating in a uniform way, downward or upward. For the quick return to equilibrium situation, the error correction speed does not appear to be identical in the two phases of expansion or contraction.

In the US, the economy is recovering. Its labour market is continuing to strengthen with rising economic activity and declining unemployment rate. The overall inflation and the measure of inflation, excluding food and energy prices is still below the target rate of 2%. So the US Federal Reserve postponed the expected rate increase from the June 14 Fed Funds rate of 1%-1.25% and the prime rate (the Fed Funds plus 3%) at 4.25%.

The price level still remains stubbornly low.

Here in India, the situation is different – low growth and expectations of inflation.

The midyear second volume of the Economic Survey 2016-17, presented a grim picture quite different from the first volume. The first volume predicted a GDP growth rate of 6.75–7.5% on the basis of stronger expectations – rise in exports, increase in consumption and better monetary conditions. On the other hand, the second volume of the survey has poured cold water on these expectations. There has been decreasing economic activity reflected in credit, investment and capacity utilisation.

Although fiscal expenditures have gone up, which are reflected in widening budget deficits to reach 5% of GDP of 2013 levels, mainly due to farm loan waivers, economic growth activity has shown signs of decline. Capacity use in manufacturing is at 74%. Business survey results indicate business sentiment in Indian manufacturing went down in the second quarter of 2017, consumer confidence is falling and households expect prices to rise.

The State Bank of India’s August 10 report on credit sums it up well:

Depressed investment cycle, and existing excess capacity in manufacturing, and deleveraging on the part of corporates to improve their credit ratings have contributed to the slowdown in credit growth.

RBI’s dividend payout

To cap it all, the RBI’s payout of its annual dividend of Rs 306.6 billion is much lower than anticipated. The government was expecting a figure of Rs 580 billion by way of dividend. The amount of Rs 306.6 billion is much lower than the figure of last year: Rs 658.76 billion.

It was thought that about Rs 5 trillion of the Rs 15.3 trillion held in the demonetised currency denominations would be sucked out. A consequent huge cancellation of liability on the part of the RBI would lead to higher profits. The government had expected a combined amount of Rs 749 billion to come in from the central bank and dividend payments from state-run banks and other financial institutions. The expected windfall would have resulted from the extinguished liability of RBI and disappearance of liability means profit for the RBI. And the dividend to the government would sustain its fiscal expansion.

About 97% of demonetised currency was returned and hence the expected windfall did not materialise. In addition, there were unbudgeted expenditures for the RBI.

One was liquidity sterilisation through reverse repo operations and the other was the printing cost of new currency notes as part of the re-monetisation exercise.

When demonetised notes were returned, banks ran a big liquidity surplus at Rs 8 trillion. The central bank’s absorption of this huge liquidity imposed huge interest costs. The RBI had to spend Rs 150 billion on printing new notes. Further, due to the appreciation of the rupee, the RBI experienced a loss in returns on its investment in US treasury bonds. All this put together, the unanticipated expenditures led to a fall in the RBI’s profits for 2016-17.

The government has now ruled out any further expansionary fiscal policy measures to step up the sagging growth rate.

With the less than expected windfall, the second volume of the Economic Survey made it clear that only a further reduction in interest rate can work to boost growth. The RBI’s cut in the policy rate on August 2 from 4.25% to 4% was seen by the government as inadequate.

RBI’s role

The RBI, with its own mandated goal of price stability, did not hide its fears of potential of inflation on the horizon.



The Monetary Policy Committee (MPC) took a view that there are increasing risks to inflation. They arise from farm loan waivers by states, rise in food prices, price revisions withheld ahead of the GST, implementation of house rent allowance under the Seventh Pay Commission and inadequate southwest monsoon rains in the southern states.

Certainly, some members of the MPC were totally against any rate cut. The financial environment was viewed as “bubbly and frothy”. The reasoning was not unsound:

“The combination of high valuations in equity and fixed income markets, an appreciating currency and the persistence of a liquidity overhang in the money market is a perfect recipe for a financial imbalance. A rate cut can amplify it if the central bank is seen as encouraging risk-taking.”

In fact, that view might have been responsible for the MPC’s decision to keep the policy stance neutral; wait and watch.

Latest data reveals that consumer prices accelerated 2.36% in July from 1.87% in June.

Thus we have the asymmetry: falling growth and rising prices.

Further, liquidity is now at the highest level. According to a broad money supply measures (M3), liquidity rose to Rs 128807.81 billion in July, an all time high from Rs 127840.78 billion the month before. The rise in liquidity has to be absorbed as an anti-inflationary measure.

The reluctance on the part of the banking system to lend is due to the fear of accumulating more bad loans. One can only blame the government for its failure to solve the long pending problem of non-performing assets, which is compounded by the banks’ unwillingness to pass on the rate cuts to borrowers in fullest measure.

Monetary policy alone will not buy growth.

T.K. Jayaraman is a research professor under International Collaborative Partner programme at University of Tunku Abdul Rahman, Kampar, Perak, Malaysia.