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Business News/ Opinion / Views/  Should Raghuram Rajan cut rates on 2 December?
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Should Raghuram Rajan cut rates on 2 December?

It may be prudent to wait for more data points before easing monetary policy in India

Reserve Bank of India governor Raghuram Rajan. Photo: Indranil Bhoumik/Mint Premium
Reserve Bank of India governor Raghuram Rajan. Photo: Indranil Bhoumik/Mint

The past few weeks have witnessed a heated debate on whether the Reserve Bank of India (RBI) should cut policy rates or maintain status quo. One simple way of looking at where interest rates should be is to apply the Taylor rule.

This yardstick, developed by Stanford University monetary economist John B. Taylor, estimates the desired level of interest rates based on two parameters: first, the output gap, or the difference between actual output and potential output, and second, the inflation gap, or the difference between actual and targeted rate of inflation.

A Mint analysis shows that the desired policy rate (based on the Taylor rule) had been above RBI’s actual policy rate since 2012. But after the latest dip in consumer price inflation (CPI) in October, the desired policy rate has fallen below the repo rate of 8%, as the chart shows. While no central bank takes decisions mechanically on the basis of the Taylor rule, it is a widely used benchmark to quantify the stance of a central banker. Senior RBI officials have often used Taylor rule estimates to justify monetary policy decisions in their public pronouncements.

To be sure, a lot depends on the assumptions about the potential output and desired level of inflation. For the purpose of this analysis, the targeted CPI has been kept at 4%, as per the suggestions of the Urjit Patel committee on India’s monetary policy framework. India’s potential output is roughly 6%, according to the last annual policy statement of the RBI, published earlier this year. So, the potential output for the analysis has been pegged at 6%. The neutral policy rate has been kept at 1%, in line with a March 2013 study by Deepak Mohanty, executive director at RBI.

The Taylor rule calculations indicate that the clamour for a rate cut is not entirely baseless. Yet, there are two key reasons why it may still be prudent to maintain status quo. Firstly, the dip in the desired policy rate is because of just one data point: the fall in inflation in October. It may be premature to lower the guard on inflation without ascertaining whether the downward trend in inflation is sustainable or not.

Secondly, like any other central bank, RBI will have to take into account global factors while determining policy rates in India. And global conditions have been far from benign over the past few months. In response to the dollar rally, which has weakened emerging market currencies, most emerging market central banks have either held on to rates or hiked them over the past quarter, as the second chart shows.

This is the second part of a two-part data journalism series on monetary policy. The first part examined Raghuram Rajan’s effectiveness as a central banker so far.

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Published: 27 Nov 2014, 11:12 AM IST
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