Once again Reserve Bank of India (RBI) governor Y.V. Reddy has reiterated that the US Fed rate cut is indeed relevant to Indian monetary policy, but not a determining factor. “RBI has its monetary policy where a number of factors are taken into account, and Fed rate cut is a relevant but not necessarily determining factor in this regard,” Reddy had said last week in Kolkata.
Coming a few days after the US Federal Open Market Committee’s (FOMC) decision to lower its target for the Federal funds rate yet again by 25 basis points to 4.25%, Reddy’s statement could well be interpreted as a pointer to the Indian central bank’s quarterly review of monetary policy next month.
FOMC, the policymaking body of the US Federal Reserve, first cut the Fed funds rate by half-a-percentage point in September to 4.75%, reversing its more than three-year-old tight money policy. This was followed by another quarter percentage point cut in October. The FOMC statement then had virtually ruled out another rate cut in December.
“Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance,” it had said after bringing down the Fed funds rate to 4.5%. However, the December statement reads very different. It says, “Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks.”
The indications are clear: There will be more rate cuts by FOMC in coming months.
This is bad news for Reddy. The widening of the gap between the US and Indian rates will put pressure on him to cut the policy rate in India. Otherwise, the local currency that has already appreciated 11% against the greenback since the beginning of the year will become stronger and the earnings of Indian exporters, in rupee term, will go down further. But the interest rate differential alone is unlikely to push Reddy to action when he reviews the monetary policy in the last week of January, as all other macroeconomic indicators are in favour of maintaining the status quo.
The wholesale price-based inflation for the week ended 1 December rose to 3.75%, the highest in three months. This is much lower than the 6.7% inflation rate seen in January and well within RBI’s comfort zone, but it is bound to rise once the government decides to raise fuel prices. Since January, prices of crude oil have jumped 47% in dollar term and this has not yet been passed on to the consumers. Once the Gujarat assembly elections are over, fuel prices are likely to be raised and even a 5% increase will have a 40 basis points impact on the inflation rate. In other words, from now on the inflation rate can only move one way, upwards.
One of the factors contributing to the rise in inflation is high money supply. Thanks to the unending capital inflows and RBI’s continued presence in the foreign exchange market, M3 or money supply growth has been 22.8% this year against RBI’s target of 17-17.5%. RBI has been buying dollars to rein in the runaway appreciation of the rupee and for every dollar it buys, an equivalent amount of rupees flows into the financial system, fuelling growth in money supply.
Bank credit growth, however, has come down to 22.3% year-on-year after around 30% growth for three successive years. This is an RBI-engineered “slowdown” and can’t be a justification for a rate cut. RBI, in fact, has taken a series of measures over the past year to tame banks’ aggression in certain sectors such as retail and real estate, where the regulator had seen signs of overheating. The latest data on industrial production also put to rest any apprehension on an impending slowdown. The index for industrial production (IIP) grew 11.8% in October, beating consensus expectations of the analyst community. Indeed, it was largely due to festive demands and a low base effect (growth in October 2006 was 4.5%), but one cannot ignore the fact that year-on-year, growth in manufacturing segment leapt to 13.3%, the strongest growth in the past seven months. Estimates by analysts in global brokerages on India’s growth in fiscal 2008, ending March, vary between 8.5% and 9.3%. Against this backdrop, Reddy should not be in a hurry to follow Ben S. Bernanke’s footsteps and cut rates.
RBI began raising interest rates in October 2004 and intensified monetary tightening last year with the rise in inflation and surge in capital flows. Since January 2006, Reddy has raised the repo rate, or the rate at which RBI injects liquidity in the system, six times, by 25-basis points each, to 7.75%. But the reverse repo rate or the rate at which RBI absorbs liquidity has remained unchanged at 6%. Reddy has also raised banks’ cash reserve ratio (CRR), which determines the amount of money banks need to keep with RBI, by 2.5 percentage points to 7.5% between December 2006 and now, taking about Rs70,000 crore out of the system.
A wider gap between the US and Indian policy rates will indeed encourage higher capital inflows, but Reddy is unlikely to respond by paring interest rates. After all, he can always raise CRR from the current 7.5% and absorb the excess liquidity that will be created from the capital flows. There could be other capital control measures, too. The rates can be cut only when India’s growth story is threatened.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org