The Monetary Policy Committee (MPC) at its meeting on Thursday unanimously resolved to keep the policy repo rate unchanged at 5.15 per cent. In line with market expectations, at its sixth and last bi-monthly for the financial year, it was resolved that the accommodative stance would continue to revive growth with the inflation rate at the targeted level of 4 per cent, +/- 2 per cent. Thus, the monetary policy has run its full course for the current fiscal with a policy repo rate reduction by 110 basis points or bps (135 bps including the February 2019 rate reduction). The question in this context is: has the front-loading approach of rate reduction, coupled with the accommodative stance, been helpful in activating the desired non-inflationary growth trajectory?

The Indian economy has been witnessing a weakening real economic growth measured in terms of GDP at constant prices (base year 2011-12), with accelerating retail inflation measured in terms of Consumer Price Index (Combined). In the December 2019 print, retail inflation was at 7.35 per cent on a year-on-year basis with a high food inflation component of 12.2 per cent.

Core inflation (excluding food and fuel) was higher at 3.8 per cent in December 2019 than that of 3.4 per cent in October 2019. Household inflation expectations, as evident from the January 2020 round of the RBI survey, declined by 60 bps and 70 basis points, respectively, for a three-month and one-year horizon.

Economic projections

The inflation outlook in the near future appears to be gloomy, as the MPC in its resolution has revised the retail inflation projection upwards to 6.5 per cent for Q4 of 2019-20 and 5-5.4 per cent in H1 of 2020-21. This has been much higher than the target rate of average 4 per cent. The upward revision of inflation outlook stems from the rise in non-vegetable food items (particularly milk, due to a rise in input cost and pulses on account of shortfall in kharif production); upward pressure on fuel prices (due to the uncertain global economic outlook and geopolitical tensions in the Middle-East); increase in input cost for services; and the announcement of an increase in customs duties on items of retail consumption in the Union Budget for 2020-21.

Domestic economic activity measured in terms of real GDP for 2019-20 has been estimated at 5 per cent, according to data from the National Statistical Office (NSO). In this regard, it is important to mention that real economic growth has been continuously slowing down since 2016-17. After recording a growth rate of 8.3 per cent in 2016-17, the economy decelerated to 7 per cent, 6.1 per cent and 5.0 per cent in 2017-18, 2018-19 and 2019-20, respectively.

Capacity utilisation in the manufacturing sector as per the RBI’s Order Books, Inventory and Capacity Utilisation Survey (OBICUS) declined to 69.1 per cent in Q2 from 73.6 per cent in Q1.

The state of the economy remains weak, with a continued negative output gap. The Budget has assumed that in 2020-21, the real GDP growth will be in the range of 6-6.5 per cent. However, the MPC’s growth outlook for 2020-21 is at 6 per cent — 5.5-6 per cent in H1 and 6.2 per cent in Q3 of 2020-21.

Revival of growth

Against this backdrop, it is important to mention that a smooth running of the economy is needed for a sustainable level of non-inflationary growth. This requires moving to a higher growth trajectory, with a retail inflation rate of average 4 per cent. The Economic Survey for 2019-20 has mentioned that the deceleration in GDP growth has to be seen in the context of a “slowing cycle of growth with the financial sector acting as a drag on the real sector”.

The Survey further mentions that a resurgence in growth is expected to begin in H2 of 2019-20. Simply speaking, conceptually, economic growth is critically dependent upon the investment rate (gross capital formation as a proportion of the GDP) limited by the savings rate (the ratio of gross savings to the gross national disposable income or GNDI).

In view of the above, let us examine the possibility of the revival of growth to its potential level to reach the aspirational target of becoming a $5-trillion economy by 2025. The incremental capital-output ratio (ICOR), investment and savings rates are critical inputs in this regard. The ICOR, as the ratio of the investment rate to the real GDP growth rate, reflects the efficiency of the economy by stating how many units of capital are used to obtain one unit of growth.

In our exercise, during the 2012-19 period (seven years), the ICOR was around 5 on average; it was in the range of 3.9 in 2016-17 and 7.1 in 2012-13. It is important to note that when the ICOR was at 3.9 with an investment rate of 32 per cent, a savings rate of 30.9 per cent and an inflation rate of 4.5 per cent in 2016-17, the economy grew at 8.3 per cent.

However, this could not be sustained further because of the weakening consumption demand and, more importantly, investment demand.

The investment demand measured in terms of the increase in gross fixed capital formation (GFCF) has been recorded at 2.3 per cent as against 9.8 per cent in 2018-19. Economic growth could also be revived with consumption demand originating from the government, but this cannot be sustained as consumption-led growth is not tenable in the long-run.

The transmission of the monetary policy to the real sector through lower bank lending rates has been weak so far, as the lending rate declined only by 55 bps on fresh loans as against the 135 bps reduction in policy repo rates. The banks and the private sector are also partners of growth, and have to be proactively engaged in the process of revival. Otherwise, non-inflationary growth will remain a far cry.

Through The Billion Press. The writer is a former central banker and a faculty member at SPJIMR. Views are personal