Bring the rate cut

India’s second-quarter GDP numbers have surprised many, showing a slowdown consistent with earlier economic signals. The manufacturing sector, in particular, has been facing a slowdown for some time, influenced by high real policy rates. This GDP performance raises concerns and presents several key policy lessons that need attention to avoid further economic downturn.

Economic Slowdown and Interest Rates

• Interest Elasticity of Durable Goods Demand: Indian consumption demand for durable goods is highly sensitive to interest rates, especially for first-time homebuyers. Persistently high real policy rates lead to a slowdown in sectors like manufacturing and construction, which are most interest-sensitive, as evidenced by negative import growth and reduced stock building by firms.
• The Role of Macroeconomic Policy: Post-pandemic, counter-cyclical macroeconomic policies helped smooth external shocks, but domestic policies failed to counteract falling export growth. Without boosting domestic demand, the slowdown in the first half of the year became more pronounced, highlighting the need for a more balanced approach in policy interventions.
• Tightening Policies and Their Impact: The simultaneous tightening of government spending, macro-prudential policies, and monetary policy during a slowdown has exacerbated the problem. A more flexible approach, including a relaxing of monetary policy, could have countered this trend and stimulated domestic demand to offset weakening exports.

Consumption and Economic Growth Factors

• Consumption Growth and Structural Challenges: Despite concerns about structural issues, private consumption has shown a healthy 6% growth, while government consumption has shifted from negative to positive growth. The economy’s slowdown is cyclical, not structural, as consumption in services continues to perform well, disproving the view that reforms are needed to revive growth immediately.
• Role of Monetary Policy in Sustaining Growth: Monetary policy must respond quickly to high-frequency data and signals. The current inflation spike, primarily driven by seasonal effects like vegetable prices, is expected to reverse. Given this, a rate cut is long overdue to ensure that high real rates do not stifle growth, especially with inflation showing signs of easing.
• Monetary and Fiscal Coordination: The coordination between fiscal and monetary policies has been critical for high growth post-pandemic. However, this coordination has weakened, particularly with the government’s focus on high food prices and the central bank’s cautious approach to inflation. This misalignment suggests the need for better long-term reforms in agriculture and fiscal strategies to reduce food price pressure.

Policy Reforms and Economic Strategies

• Agricultural Policy Reforms: India's agricultural policies need restructuring to shift consumer demand towards non-grain food items, which would reduce the government's dependency on food price control measures. Encouraging private participation in vegetable supply chains and reducing intermediaries can help farmers earn more while lowering consumer prices.
• Opportunities in Domestic Fuel Prices: Reducing domestic fuel prices could provide further space for economic growth. By cutting rates, monetary policy could be more supportive, helping to balance inflationary pressures while stimulating domestic demand.
• Banking Sector and Interest Rates: Indian banks need to lower their interest margins, which are among the highest globally. Although banks resist rate cuts due to fears of reduced deposit returns, the large profits made during high-interest periods can be used for restructuring, and regulators must ensure these special interest groups do not derail national economic objectives.

Practice Question

Q. Critically analyze the causes behind India’s economic slowdown in the second quarter and suggest policy measures that could be implemented to sustain long-term growth.