India’s inflation rate rose to 5.6% for the week ended 10 January, but most economists and bond dealers say the Reserve Bank of India (RBI) has sufficient room to cut interest rates when it announces its quarterly review of monetary policy on Tuesday, given that the inflation trajectory continues to be southwards.
Rising food prices pushed the inflation rate up from 5.24% in the previous week as about four million truckers went on a nationwide strike between 5 and 12 January, disrupting transportation of food and manufacturing goods in many parts of the country.
Wholesale prices rose for the first time in nine weeks and on every Thursday of these weeks, after the commerce ministry’s announcement of the inflation numbers, economists and analysts saw room for RBI to cut rates. But the banking regulator has cut rates only four times in the past 16 weeks. Had the correlation between inflation and policy rates been so strong and obvious then one would not need a central bank to formulate monetary policy.
RBI has cut its repo rate, or the rate at which it injects liquidity into the system, by 350 basis points to 5.5% since October. One basis point is one-hundredth of a percentage point. It has cut the reverse repo rate, or the rate at which it drains liquidity from the system, by 200 basis points to 4%. Both the policy rates are now at historic lows. Besides, RBI has also cut the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank, by 400 basis points to 5%, releasing about Rs1.6 trillion into the banking system. Banks’ statutory liquidity ratio, or the percentage of deposits banks need to invest in government securities, has been cut by 100 basis points to 24%, releasing another Rs40,000 crore to meet demand for credit by companies.
Also Read Tamal Bandyopadhyay’s earlier columns
Eight of 16 economists surveyed by Bloomberg last Thursday said RBI would lower its benchmark repo rate by 50 basis points to 5%. A majority of bond dealers, surveyed by another news agency, are of the opinion that RBI should lower its policy rate as well as CRR to bolster the slowing economy. Had the formation of monetary policy been a democratic process, the central bank’s policy rates would have been much lower by this time.
Indeed, analysts have been demanding that the policy rate should come down to 2% or so as inflation will drop to near-zero during this year and the economic slowdown will deepen. If the US Fed funds rate can come down to 0-25 basis points, the European Central Bank’s policy rate to 2% and the Bank of England’s rate to 1.5%, why can’t RBI bring down its rate drastically? Well, RBI cannot do so, because it has an administered savings bank rate at 3.5%. Even though money kept in current accounts with banks do not earn any returns, savings accounts earn 3.5% and the policy rate cannot come down below this. In other words, the 3.5% policy rate in India is equivalent to zero in the US, and the floor for any policy rate. This can be brought down only if RBI cuts the savings rate. But with elections round the corner, it cannot do so because this will hurt savers.
So, RBI does not have too much headroom for cutting rates. The reverse repo rate can go down by another 50 basis points to 3.5% and the repo rate, even if RBI shrinks the corridor between two policy rates to 100 basis points, to 4.5% from the current level of 5.5%.
At present, the corridor, or the gap between the two rates, is 150 basis points and the overnight call money rate, or the rate at which banks borrow from each other to tide over their temporary asset-liability mismatches, should move between the two rates.
There is no harm in waiting and watching the trend for a few more weeks before it announces another round of rate cut. Those who are aggressively pitching for action now argue that RBI has nothing to lose if it cuts the rate as it can always reverse its decision if the situation changes dramatically. I would not buy this argument as governor D. Subbarao can cut rates any time and does not need a policy announcement to do that. In fact, all his rate-related decisions have been announced outside of the RBI policy. In other words, he does not need to wait for three months for the next rate cut when he will announce the annual policy.
Sherman Chan, an economist at Moody’s Economy.com, and many others say the monetary easing cycle will continue through the first half of 2009, as growth momentum will significantly ease and global financial market turmoil seems far from over. But the inflationary pressures will be back in the second half of the year and RBI may start tightening its policy when concerns over growth disappear in 2010.
It’s difficult to make any prediction for the next one year as there are too many uncertainties all around. Looking back, who knew that inflation, which was slightly more than 4% in January 2008, would inch close to 13% by August and threaten to drop to zero in a year?
Similarly, the price of crude oil, which was around $95 per barrel last January, crossed $145 by mid-2008 and is now less than $40. RBI was taking steps to stem capital inflows in the first half of 2008 and now it is desperate to encourage inflows. In uncertain times, let’s not expect predictable policy responses from RBI.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to email@example.com