BackIt will be hard for RBI to cut rates
If the central bank lowers rates when inflation is still high, it’s an admission its policy has not worked
Premium(Pradeep Gaur/Mint)
Traditionally, monetary policy has been motivated by the twin goals of fuelling growth and containing inflation. Accordingly, we attribute a Keynesian face or a Friedman-like policy stance to it. Interestingly, in the last two years or so, there is a degree of skepticism about whether these theories really make sense when evaluating the efficacy of the monetary policy.
Further, two other dimensions have been added. The first is what has been called “pressure by the government" and the second is “market expectations".
One is still not sure whether these two really affect policy formulation; but, given that the finance minister keeps making statements on the need to lower interest rates and the Reserve Bank of India (RBI) holds meetings with bankers, one never really knows if such things matter and become self-fulfilling. Also, in April, RBI lowered the repo rate, or the rate at which it gives short-term money to banks, with a caveat that we should not expect more rate cuts soon. This came at a time when the the finance minister spoke about lower interest rates after presenting the Union budget. There appears to be some merit in believing that these two factors also matter for RBI.
Given these motivations, what can we expect? Growth is stagnant. The recent positive industrial growth numbers should not cloud our vision that things have changed drastically. While a turnaround from negative to positive growth is good news, we need to wait and see if this is sustainable from now on. At best, one can say that growth has bottomed out.
There’s a status quo on inflation, too. Wholesale inflation rose 7.8% in September with all segments coming under pressure. Retail inflation is closer to 10%. Inflationary expectations are high, given that fuel prices have been increased and that the kharif (or winter) crop will be below optimal.
Now inflation is on the supply side but RBI has, in its various policies, taken a varied approach to inflation. At times, it was core inflation that was targeted; on other occasions, it was food inflation. More recently, it has spoken of retail inflation. Whichever way we look at it, none of these numbers has come down significantly to warrant a change in monetary stance.
Also, if RBI lowers rates when inflation is still high, then it is an admission that the policy has not worked; and that, as a corollary, its original approach was not right. Therefore, it is hard for RBI to lower rates.
The so-called pressure put by the government can be an important factor, considering that the government has done its bit for reforms and fiscal consolidation, albeit more through announcements than actions. With banks also looking at the regulator to lower rates and the cash reserve ratio (CRR) or the portion of deposits that banks need to keep with RBI, there is indeed pressure on the central bank.
Given all this, RBI could go in for a CRR cut, though admittedly liquidity is not an issue for the system today. Still, this will placate the market and leave the banks to decide on interest rates.
The CRR cuts have not, in the past, been very effective in lowering rates. While banks have claimed that they will be in a position to lower rates if CRR is lowered, past experience does not provide such an indication. Still, cutting CRR and leaving the policy rate intact should send the right signal to the market, though this may not be adequate to excite the market which is banking on a rate cut.
I expect a CRR cut of 25 basis points (0.25%) with no change in the policy rate. One basis point is one-hundredth of a percentage point. Also, some sort of payment on CRR balances can be thrown in as an icing on the cake to make banking stocks tastier.
The Reserve Bank of India will present its second quarter review of monetary policy on 30 October against the backdrop of a persistently high inflation and slowing economic growth. The finance ministry has been pushing for a calibrated rate cut to give a fillip to growth. Will the banking regulator oblige? This is the first in a series of columns by economists and analysts on what to expect from the policy.
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