The Reserve Bank of India’s (RBI’s) annual monetary policy review opens by expressing concern on the state of the economy. While inflation has moderated, “it remains sticky and above the tolerance level, even as growth has slowed”. And, worries on the fiscal deficit, current account deficit and asset quality continue. Still, the central bank’s concern about slowing economic growth guided its decision to cut the benchmark interest rate by 50 basis points, marking a strong start to the long-awaited reversal in monetary policy tightening.
What will this rate cut achieve? A lowering of interest rates should lead to a cut in both deposit and lending rates. Companies will find it cheaper to fund their working capital needs, while interest rate-sensitive sectors such as automobiles and real estate may see demand improve. But the risk is that a return to consumption-led growth may again see inflation rise. Cutting interest rates does nothing to solve the problem of a deficit in investment-led growth. Gross fixed capital formation declined by 4% in the second quarter of 2011-12, and by 1.2% in the third quarter.
In 2012-13, RBI’s baseline GDP (gross domestic product) growth estimate is 7.3%, higher than 7% in 2011-12, assuming a normal monsoon and leading indicators suggesting a turnaround in industrial growth. The central bank is confident that the economy will revert closer to its post-global financial crisis trend growth in 2012-13, which leaves little room for monetary policy easing without aggravating inflation risks. It then goes on to say that the main reason for the lower trend growth is supply bottlenecks in areas outside its influence—infrastructure, energy, minerals and labour. The government has much to do in these areas.
A key comfort for RBI is that core inflation—or inflation in non-food manufactured products—is down to 4.7% in March. But while prices of cotton and man-made textiles declined, that of others have risen. Moreover, higher indirect taxes levied in the budget will reflect in higher product prices, too. The increase in crude oil prices has to be passed on, says RBI. That may lead to inflationary pressures as well. Most worrying is that food inflation is making a comeback. If it continues, it may put pressure on wages, which, in turn, may accelerate inflation across the board.
Despite the central bank’s concern about the upside risks to inflation, its assessment of below-trend economic growth, coupled with moderation in core inflation, has guided its decision to cut rates.
But it also surprises by tempering market expectations on further rate cuts, stating that “the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates”.
Unless RBI sees further deterioration in growth, or improvement in macroeconomic conditions, it may not yield to calls for further rate cuts.
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