The decision of the US Federal Reserve to make a 25 basis points cut in its federal funds rate is a sure indication that the threat of a slowdown in the US economy is far more significant that earlier believed. While the earlier cut of 50 basis points, in mid-September, after 17 successive increases since June 2004, was guided mostly by the need to inject quick liquidity into a market hit by the subprime crisis, the current cut is more in response to fears that a continued slump in the US housing market could bring on recessionary conditions. Yet, a sharp economic slowdown seems unlikely, given that the US economy has shown some unexpected buoyancy of late, as seen in its latest production data. While the US Fed has spoken of a ?balance? of inflation and recession risks, analysts believe that it is giving the former threat short shrift, given the rising oil prices and declining dollar. This may be on account of lingering subprime worries.
The Fed?s actions were being closely watched in India largely because of the dramatic effect of the September cut, which magnified capital inflows into the country, prompting talk of capital controls and setting the stage for Sebi?s restrictions on PNs. Would this cut do something similar? One argument is that unlike last time round, market players had already ?priced in? another cut into their investment and allocation plans, so nothing much will change. Also, the RBI is thought to have raised the banking sector?s CRR at least partly as a pre-emptive move with precisely such a Fed rate cut in mind. In this view, the inflows problem will not worsen. The RBI, saddled as it is with the cost of sterilising larger capital inflows, which forced it to raise the ceiling under the MSS twice over the year to Rs 2,00,000 crore by end October, is well on its guard this time. Yet, the effects of a widening of interest rate differentials between the US and India may prove less predictable than many suppose, and India?s monetary management could still be overwhelmed if the ?pricing in? assumption turns out to be hollow as far as FII decisions on the Indian capital market go. Sure, the CRR could be raised again, but hurting banks beyond a point would be unwise. A gradually appreciating rupee may then be the best way to deal with the problem. But for this, the RBI needs a cohesive plan.