When do we see a rate cut, Dr Reddy?

When do we see a rate cut, Dr Reddy?
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First Published: Tue, Jan 29 2008. 11 50 PM IST

Tamal Bandyopadhyay
Tamal Bandyopadhyay
Updated: Tue, Jan 29 2008. 11 50 PM IST
Tamal Bandyopadhyay
Central banks across the world now belong to two camps —those that are cutting interest rates and those that aren’t. The US Federal Reserve, which had raised its policy rate 17 times between June 2004 and June 2006, from 1% to 5.25%, started cutting it in September 2007. Over the past five months, it has brought it down to 3.5%, and by Thursday, it could be 3%, if market expectations of a 50 basis points rate cut are met by the Fed’s policymaking body Federal Open Markets Committee. The Bank of England cut its rate by 25 basis points to 5.5% in December; the Bank of Canada by 50 basis points to 4% in December and January.
Central banks that have tightened their policy rates in recent months include Reserve Bank of Australia, the People’s Bank of China, the Banco Centra de Chile, Banco de Mexico and the Reserve Bank of India. Although its latest policy statement on Tuesday did not announce any rate hike, it clearly said liquidity management is high on its agenda and it would use all monetary tools at its disposal, including raising cash reserve ratio (CRR), which defines the balance Indian banks need to keep with the central bank, and flotation of bonds under the market stabilization scheme (MSS) to fight inflationary pressures. In fact, but for the Fed’s 75 basis points rate cut, it seems RBI would have gone for another round of CRR hike.
Ever since it started its tightening cycle in October 2004, RBI has raised the reverse repo rate (at which it absorbs liquidity in the system) from 4.75% to 6% and the repo rate (at which it adds liquidity to the system) from 6.25% to 7.75%, and CRR by 200 basis points to 7.5%, to soak up excess liquidity, which stokes inflation, from the system.
China, which is seeing its inflation rate at an 11-year high, is also using a mix of policy tools, including hike in rates and rise in banks’ reserves to fight inflation. It raised its lending rate to 7.47% from 7.29% in December. However, macro economic realities in China are very different from India. The inflation rate here, despite all the risks outlined in the policy document, is not alarming as yet and the nation’s need for investments is huge. There is a slowdown in bank credit growth and industrial production is moderating.
So, Reddy may not be able to wait and watch, holding on to his tight money stance for long. Another rate cut by the US Fed will widen the interest rate differential between the two countries further and encourage more capital flow into India. If Reddy does not cut the rate, he will have to soak up the excess liquidity through MSS and CRR—a more expensive way of managing liquidity than paring interest rates.
A New Delhi-based economist, who claims to know him well, told me on Monday that Reddy would cut rates during his tenure as governor. The last cut was effected by former RBI governor Bimal Jalan in August 2003 before Reddy took over the reins in September. Reddy will announce two more monetary policies—one annual policy and one quarterly review—before he steps down as governor. I took a bet with the economist, saying Reddy would cut rates in one of his policies or even outside a policy. This is because, despite its focus on the domestic economic scenario, RBI always follows the Fed, although with a lag effect. For instance, the Fed started hiking its policy rate in June 2004 and RBI caught up with it in October that year with a 25 basis points hike. Historically, RBI has never ignored cues from the Fed. The rates in India will be cut. The question is: When?
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to bankerstrust.com
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First Published: Tue, Jan 29 2008. 11 50 PM IST