Seven days after change came to Washington, D C, change has come to the Reserve Bank of India’s (RBI) monetary policy review. The January statement is shorter, crisper and more lucid than past efforts.
The policy matched market expectations by holding policy rates, providing a downbeat growth assessment and acknowledging the likelihood of a further sharp decline in wholesale inflation by March. However, the statement contained precious little on inflation beyond March, or growth estimate for fiscal 2010. In his post-policy statements, the RBI governor addressed the inflation issue and suggested that the central banker will not be unduly worried if and when the Wholesale Price Index (WPI) slips into negative territory. This is the right stance as any talk of deflation in a supply-constrained economy is conceptually flawed. The central bank was also right to point at the need to take into account all the different inflation indicators and the likelihood that inflation expectations may not fall as steeply as WPI. On growth estimate, RBI seems to have ducked the issue. Market expectations of growth in fiscal 2010 centre on a sub-6% outcome. The central bank’s bleak assessment of global environment and drying up of non-banking funding sources imply that RBI may be sympathetic to such a prognosis.
However, taking its role as a cheerleader of the economy seriously, it has refrained from deriving logical conclusions from its assessment. By pointing out the lags attending monetary actions and reminding banks that it can be decisive when it needs to be, RBI seems to be hinting that there will be a temporary pause before rates are cut again.
This introduces volatility in markets and gives an excuse to banks to delay rate decisions. The issue here is not about the timing of rate decision but the desirability of lowering policy rates. As RBI pointed out, the situations in India and advanced economies are different. In advanced economies, where nominal rates are approaching zero, monetary policy has lost its effectiveness and fiscal policy is the only game in the town. In India, with fiscal balances out of kilter and a serious risk of government borrowing crowding out private investment, RBI has to do the heavy lifting.
In my view, RBI should hold firm and not cut rates unless output data comes out much weaker than its internal assessment. The reverse repo rate at 4% is low enough and further lowering could lead to misallocation of resources. There is also the small matter of exit policy—when the time comes to hike rates, the central bank will find obstacles in its path.
More important, low interest rates and excessive build-up of debt can turn addictive as the examples of Japan and the US show. While I do not rule out further cuts by RBI in the face of pressure from dire data, I hope it raises the bar for the rate decision and stops holding out hopes for further easing. Borrowing the playbook of European Central Bank president Jean-Claude Trichet might be helpful; although markets may stop appreciating the benefits of lucidity in such a scenario!
A. Prasanna is head of research, ICICI Securities Primary Dealership Ltd.