Monetary policy has limitations, govt should act more to revive economy: SBI economists

Using a formula, they estimated the "lower bound" of interest rates — below which the gains of rate cuts start reversing — at 3.5 per cent for India as against the Reserve Bank of India's (RBI) policy repo rate of 4 per cent.

The country needs to adopt an "activist" fiscal policy rather than depending on the monetary accommodation alone for turning the economic fortunes, economists at SBI said on Monday.

Using a formula, they estimated the "lower bound" of interest rates — below which the gains of rate cuts start reversing — at 3.5 per cent for India as against the Reserve Bank of India's (RBI) policy repo rate of 4 per cent.

The RBI has cut rates by a cumulative 1.15 percentage points since the onset of the coronavirus pandemic but paused at the last review because of high inflation. The government has promised to spend an additional less than 2 per cent of the GDP as part of a stimulus package to help the economy which is much lower than what other nations have done.

"We believe any further rate cuts will have the unintended impact on the economy. Instead, we strongly recommend for India an activist fiscal policy," the SBI economists said in a note.

"Fiscal expansion is a must," they added.

In the note, the SBI economists said providing fiscal stimulus is the most effective solution in the current pandemic and it should be taken up immediately by India just like other countries.

They said countries are providing sizable fiscal support through budgetary measures, and off-budget liquidity support measures taken by the governments in the US and Europe to protect vulnerable firms and employees during the lockdown have largely met their goals.

As the exit phase begins, policy needs to pivot toward supporting the recovery, they said adding that in the Indian context, this may include providing fiscal support to help the demand side.

Elaborating on the lower bound of the interest rates, it said such a level is given by the reversal interest rate, at which accommodative monetary policy reverses its effect and becomes contractionary for output.

"If the central bank reduces the policy rate below such 'reversal interest rate', the monetary policy rate depresses rather than stimulates the economy. Importantly, such reversal interest rate is not (necessarily) zero," they explained.

The economists said they used a 2018 paper to extend the concept of reversal interest rate in the Indian context with suitable modifications and pegged the rate at 3.5 per cent.

There is a "clear evidence" of reversal repo rate creeping up over time, and in that sense, banks will always prefer to hold assets of longer duration, they said. The economists cited the example of bank having assets of a shorter duration and said that in such a scenario, longer interest rate cut might lead to larger net interest income profit losses than fixed income capital gains.