The drumbeat for lower interest rates is getting louder by the day, and it will be clear on Tuesday whether Reserve Bank of India (RBI) governor D. Subbarao has succumbed to the pressure.
There are four sets of economic parameters that Subbarao will have to consider. The picture that emerges is far more complicated than what is commonly accepted.
First, there is no doubt that the Indian economy is growing below potential, which is usually a clear signal to lower interest rates in a bid to stimulate demand. However, what has pulled down growth is not a lack of aggregate demand, but severe problems on the supply side which have their roots in the mismanagement of the economy from New Delhi.
Second, the inflation trends are mixed. While core inflation is now at a comfortable level the same cannot be said about rising consumer inflation. The divergence in the two measures of inflation complicates the task before the Indian central bank. Core inflation is the parameter it has better control over, since volatile food and fuel prices are not included. But any modern central bank also has to pay attention to inflation expectations, and these depend on the prices consumer pay in the markets. There are signs that inflation expectations have drifted up, leading to demands for higher wages.
Third, Subbarao has often said that any interest rate reductions can only come after credible fiscal correction by the government. There has undoubtedly been far greater appreciation of the public finance mess since P. Chidambaram became finance minister in July. He has squeezed public spending this year and promised a modest reduction in the fiscal deficit in fiscal year 2014. Subbarao may be under pressure to now walk his talk, but whether the government sticks to its intentions to impress the credit rating agencies or loosens the purse strings before the 2014 general election is an open question.
Fourth, Subbarao added a new element to the policy mix in January, when he said that his policy decision is not dependent on the inflation trajectory alone, but will also take into account the record current account deficit, which most economists recognize as the single biggest risk to economic stability. There are no signs of the external deficit shrinking despite the growth collapse.
So the signals are mixed, but on balance the structural nature of the slowdown, mixed inflation trends, fragility of the fiscal path and a persistent current account deficit are, in this newspaper’s opinion, ample reason for Subbarao to resist cutting rates.
And remember: a cumulative 75 basis points of rate cuts since April and large open market operations to inject liquidity are hardly signs of an ultra-hawkish central bank.