The Reserve Bank of India (RBI) governor Y.V. Reddy has to take one of his most complex decisions today, when he announces the new monetary policy. Will he cut interest rates or not?
Crafting monetary policy in an open economy is a far more difficult task than it was in the days of closed borders and minimal global capital flows. And the new monetary policy is to be announced at a time when global markets have been unsettled by recession fears—when open economy issues will be in the forefront, in other words.
From a purely domestic viewpoint, there is hardly any case for a cut in interest rates. Sure, economic growth is likely to slow in the next four quarters, perhaps to around 8.5%.
There are already early signs of a slowdown in industrial growth, in the demand for some types of consumer goods and growth of bank credit.
Though the strong rupee has not yet dented exports, it is quite likely that an appreciating currency will be a deflationary influence over the medium term. These bits of data have led to renewed calls for lower interest rates. But what those making these demands seem to forget is that RBI should be quite comfortable with this situation.
The central bank has been saying for quite some time— correctly, in our opinion—that India can sustain a long-term growth rate of around 8.5% a year, given the current rates of savings and investment. Sustained growth above this level is likely to spark off inflation —as it did about a year ago when there were concerns that the Indian economy had started overheating.
It is also argued that the central bank should take a risk and cut interest rates, since inflation is still within the comfort zone of below 4%. But the inflation rate in India is understated. First, consumer prices are rising at a far faster pace than the headlines about the wholesale price index suggest. Two, the government has not raised domestic fuel prices and hence artificially capped the inflation rate.
RBI is likely to look beyond the published inflation numbers and see what its consumer surveys show. Our guess is that they will reveal that inflation expectations have grown in recent quarters. And central bankers should ideally pay close attention to inflation expectations since they directly affect decisions to consume, save and invest.
So, it is not surprising that the consensus till recently was that RBI should not cut interest rates right now. But that consensus crumbled after the recent bout of global stock market volatility and the US Federal Reserve’s subsequent 75 basis points cut in the target federal funds rate. That was a panic reaction and uncalled for. But it has left the financial markets thirsting for more. Traders are now betting on a further 50 basis points cut in the federal funds target rate. That has widened the difference between the Indian and the US interest rates, and a wider differential is usually a catalyst for higher capital inflows into India.
But that depends on the global risk climate. A dramatic repricing of risk amid a slowing global economy could lead to a flight of capital from emerging markets such as India, despite higher interest rates here. Investors are jittery right now, and a flight to safety could send money into safe havens such as gold.
There is no doubt that the economic balance has changed over these past few weeks the world over, with recession risk and financial instability getting more attention than inflation pressures. India has been no exception to this attitudinal shift. But the inflation risk has not gone away just because people are looking in another direction.
However, we believe that the Fed fired its gun in a bout of panic. There is no reason why the cooler heads in RBI should follow suit.
Does India need lower interest rates at this juncture? Write to us at firstname.lastname@example.org