Rarely has there been such a clear case for an interest rate cut in India. And that is what Governor YV Reddy of the RBI must do when he announces the monetary policy this week. This financial year has seen the central bank raise rates to cool down an overheated economy. But inflationary fears were relevant in early 2007. Early 2008 is different. The economy is no longer in overheating mode. If anything, there are signs of an imminent economic slowdown. Corporate profit growth has declined. Exports are growing slower. Consumer goods production has slowed down. It is important to remember that monetary policy works with a time lag. This means that the RBI cannot wait until a slowdown actually sets in. It needs to act in anticipation. It took more than a year of monetary tightening for the Indian economy to come off its 10% growth trajectory. Dr Reddy must be very careful if he does not want to cool the economy further. If all else were unchanged, one could still have argued that a policy of no further tightening is good enough. However, that is not the case at this juncture. The world is bracing itself for a slowdown in the biggest economy in the world, the US, which constitutes one-fourth of world GDP. If the US slows down, India will be affected through many direct and indirect channels. The RBI needs to take this into account in its credit policy. History has taught us that too much tightening can suffocate. The rate hikes of mid-1990s are seen as having partly brought on the Indian sluggishness that began in mid-1996. Surely, the central bank doesnt want to be held responsible for a recurrence, especially since the dangers now are different and the range of probabilities wider.
Another consideration must be the role of the rupee in the Indian economy. The export sector is much bigger now. High interest differentials draw in more capital inflows and push the rupee upwards, which could hurt exports even more grievously. Holding the rupee down is certainly not recommended. Imposing additional capital controls would also be a bad way to deal with this, since such stern action could raise the countrys risk profile globally, and without achieving much. Lowering interest rates, thus reducing interest arbitrage opportunities, is a better solution. In all, a rate cut will be a win-win.