Why Raghuram Rajan should consider a rate cut: 5 facts

Written by FE Online | New Delhi | Updated: Mar 31 2014, 22:30pm hrs
RBI credit policyThe odds are the RBI will wait one or two more credit policy cycles before taking a call on which way to move interest rates.
There are several reasons why Raghuram Rajan should consider a rate cut tomorrow as he announces Reserve bank of India (RBI) monetary policy. Here's why:

*All data is pointing in the direction for a rate cut. Wholesale inflation rates are down to a 9-month low from 7.52% in November to 4.68% in February, and consumer price inflation is down to a 2-year low from 11.16% in November to 8.1% in February. Indeed, since much of the fall was due to a collapse in vegetable prices that are not influenced by monetary policy, there is an argument to be made that RBI hiked rates when the problem was a transient one.

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* Another reason for cutting rates is that with credit demand in the economy simply refusing to pick upit grew 14.6% in February 2014 versus 16.1% a year agobanks are not only refusing to pass on interest rate hikes to customers, they are even cutting interest rates. Interest rates are driven by market conditions, not just by RBI hiking rates.

* But, those opposed to rate cuts argue, core inflation continues to remain elevated. So, were demand to return, there will once again be inflationary pressures that could easily flare up in an easy monetary policy regime. The problem with this argument is that with the rupee appreciating, along with softening of global commodity priceswhich will be helped by Chinas further slowingthe pressure of imported inflation is anyway diminishing. Nor is it correct to say that core inflation is not responding. It is stickier than headline inflation, but in the case of CPI, ex-fuel core inflation is down from 11.6% in November to 8.3% in February. The larger point is, apart from food inflationwhich doesnt respond to monetary policy anywaythere are few signs of significant demand pressures that can cause inflation to rise anyway.

* How RBI chooses to react depends, in a large manner, on what its strategy is. If it remains one biased towards inflation targetingsomething the finance minister is clear he has rejectedthen the central bank may be tempted to keep interest rates at elevated levels. Consumer inflation levels of 6% over the next two years will require CPI-inflation levels in manufactured products to come down a lot more than what they are today.

* RBI may also want to see how the rupee behaves. If, for instance, there is no stable government after the elections and FIIs start pulling out, the rupee could depreciate and put pressure on inflation. The converse, though, is that the rupee could further strengthen if there is a stable government.

* The odds are the RBI will wait one or two more credit policy cycles before taking a call on which way to move interest ratesmore so since banks are ready to lower interest rates for good borrowers anyway. Over the medium-term, were the new government to keep to a tight fiscal policy, stay away from excessive hike in procurement prices and push through important supply-side reforms that will add to capacity creation, you can expect a faster reduction in inflation pressure.

Also read: RBI may keep rates unchanged on Tuesday