Why RBI should ignore calls for a rate cut
The September quarter GDP numbers weaken the case for a rate cut by the central bank. Calls for reducing interest rates had started even before the economic growth numbers were released.
The government seemed to imply this to the Reserve Bank of India (RBI) monetary policy panel: We have announced a bank recapitalisation package, plugged loopholes in the bankruptcy code and simplified the goods and services tax (GST). Now, you do your bit.
The October monetary policy statement talked about making the environment conducive for reinvigorating private investment through “adequate recapitalisation of stressed banks, closing the infrastructure gap, simplifying the GST, hastening clearances and rationalizing procedures by states relating to investment proposals.” The central government has certainly done its bit.
Now, growth has picked up, albeit modestly. GDP growth for the quarter ended September has come in at 6.3%. Thus, there is no compelling reason for the central bank to reduce rates when inflationary risks loom. Growth projections for the second half of the year from private economists and multi-lateral institutions are higher. The central bank has also projected that gross valued added (GVA) growth will accelerate to 7.1% and 7.7% in the December and March quarters, respectively.
Investment demand growth also rebounded to 4.6%, a five-quarter high. Indeed, factors such as the bank recapitalisation plan and simplifying the GST structure will make economic growth durable. The monetary policy committee (MPC) indicated as much in the October review when it said that “various structural reforms introduced in the recent period will likely be growth augmenting over the medium to long term by improving the business environment, enhancing transparency and increasing formalization of the economy.” Recap and GST tweaks happened in November.
In that context, the panel should not bow to pressure and cut rates. Growth is anyway set to accelerate, but inflation risks have not been fully mitigated. Remember that a cautious central bank had raised its inflation target to 4.2-4.6% for the second half of this fiscal year from 4-4.5%.
Data that has come in since the last policy review does nothing to assuage concerns about upward inflationary pressures. In October, Consumer Price Index (CPI)-based inflation rose to a seven-month high of 3.58%. Core inflation has remained sticky at around 4.5% over the last three months after dipping below 4% in June. The recent reduction in GST rates will show up in inflation numbers with a lag. Thus, the headline numbers are only likely to inch up for a variety of reasons, say economists.
One, the sharp dip in the prices of vegetables and other perishables in the aftermath of demonetization is history. Tomato and onion price rises are more frequently making it to the headlines; data show they were among the highest contributors to overall retail inflation in the past three months.
Two, the prices of commodities have been rising, particularly that of crude oil. Oil prices have risen 14% since the last monetary policy meeting. The Organisation of Petroleum Exporting Countries (Opec) is meeting late Thursday to extend production cuts which will keep prices firm. Rising oil prices are a threat to inflation, also because the government does not have the fiscal room to cut excise duty on petroleum products. Thursday’s data release, which shows April-October fiscal deficit at 96% of the full-year target, says it all.
For now, the government has committed to stick to the fiscal deficit target of 3.2% of GDP. But the reduction in GST rates has added an element of uncertainty. The October collection numbers add to fears of missing the target. Moreover, this February budget would be the last budget of the current government before election year. That’s the time most governments yield to the temptation to go populist. It would make sense to wait till the Union budget in February to take a decision. RBI would want the government to stay the course, especially at a time when state governments have announced farm loan waivers and could increase their borrowing. On earlier occasions, governor Urjit Patel has warned about the inflationary impact of these debt waivers.
Lastly, RBI has to stay cautious at a time when global central banks are reducing their balance sheet size. Recently, Jerome Powell, Donald Trump’s nominee for the chair of the US Federal Reserve, said he sees the case for a rate hike in December “coming together”.
That makes the case for RBI to stay its hand stronger.
Ravi Krishnan is assistant managing editor, Mint.