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Business News/ Industry / Banking/  Curb your enthusiasm on rate cuts
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Curb your enthusiasm on rate cuts

Fuelling rate cut expectations is the combination of the rising US dollar and falling commodity prices, especially oil

RBI is unlikely to join the rate cut club, at least for the time being, when it concludes its latest bimonthly policy review on 2 December. Photo: BloombergPremium
RBI is unlikely to join the rate cut club, at least for the time being, when it concludes its latest bimonthly policy review on 2 December. Photo: Bloomberg

Rate cuts are suddenly in vogue across Asia. The Bank of Korea has cut rates twice in recent months, returning the policy rate back to its all-time low of 2%. The People’s Bank of China recently trimmed key policy rates for the first time since 2012. And financial markets are betting increasingly heavily that the Reserve Bank of India (RBI) will quickly follow suit, with close to three 25 basis points rate cuts over the next year now priced in. A basis point is one-hundredth of a percentage point.

Fuelling rate cut expectations is the combination of the rising US dollar and falling commodity prices, especially oil. A year ago, the prospect of the end of quantitative easing by the US Federal Reserve and the fear of earlier-than-expected rate hikes triggered the so-called taper tantrum, sending emerging markets, especially India, into a tailspin. Rate hikes, not rate cuts, were the result.

Eighteen months on, and with the third round of quantitative easing now ended, the looming prospect of the first interest rate hikes in the US in nearly a decade is not triggering a global interest rate shock, but rather a surge in the dollar against major currencies and sharply lower commodity prices. Slowing Chinese growth and fast-growing US oil output are, of course, other factors, but the damping role of the strengthening greenback seems clear. The net result is that longer-term US interest rates are being capped, limiting the fallout on emerging market currencies such as the rupee, while lower commodity prices are pushing down headline inflation rates, creating more short-run policy space for many central banks to potentially ease policy.

But RBI is unlikely to join the rate cut club, at least for the time being, when it concludes its latest bimonthly policy review on 2 December. Headline inflation is certainly tumbling, sliding to a six-year low of 5.5% in October. And favourable base effects from a jump in prices last November mean even lower inflation of below 5% looks likely next month. Stripping out volatile food and energy prices, core developments, which RBI attaches more weight to, are also encouraging. Underlying the Consumer Price Index (CPI) is finally showing more responsiveness to spare capacity, easing to a record low of 6%. Meanwhile, core wholesale price inflation, not an explicit target for RBI any more but still a key guide to upstream pressures, has tumbled to under 2%, also a six-year low.

Propitious as short-run developments appear, it is far too early to sound the inflationary all-clear. The outlook for crude oil prices remains necessarily uncertain; a rebound could rapidly change inflation calculus. Moreover, the outlook for food inflation is also unclear. Base effects temporarily become demanding heading into 2015. Combined with the lagged impact of this year’s deficient monsoon on the autumn harvest, a rebound in food inflation should see headline CPI inflation jump back up towards 7%.

It would still be well below the 8% inflation target recommended by the Urjit Patel committee that RBI has adopted as its policy lodestar, but the temporary recoil in itself should not be overly troubling. The key is where inflation is now expected to go after its likely rebound in early 2015—further progress along its desired glide path towards the 6% target by early 2016 as RBI desires or unhelpfully sticky around 7%? RBI’s last policy review suggested more risk of the latter with its inflation forecast for early 2015 centred on 7% by early 2016. Lower oil prices will be pushing RBI’s revised inflation projection lower as will signs that demand-push pressure on food inflation is fading as rural real wage growth subsides on the back of lower minimum support prices and tighter control over rural welfare spending.

The central bank’s key concern and the greatest impediment to lower rates, however, is that gauges of inflationary expectations remain rooted in double-digit territory. Indeed, far from falling, RBI’s last survey of household expectations worryingly showed one-year ahead expectations picking up to an all-time high. Expectations should begin to respond adaptively to the lower inflation rates now being seen, but until clear evidence of this emerges, RBI will remain concerned that any sustained pick-up in the pace of economic growth will quickly see inflation pick back up.

For CPI inflation of 6% or lower over the medium term to be locked in, monetary policy must be kept tight even as the inflation conjuncture improves. Households may be starting to see lower inflation, but they must believe that it will last. This is where the central bank’s words and actions must make the difference, delaying rate cuts until signs emerge that credibility is being rebuilt. Only when clear evidence that inflationary expectations are decisively pulling back will it be safe for RBI to join the rate cut club.

Richard Iley is chief Asia economist, BNP Paribas SA.

This is second in a series of three articles ahead of the Reserve Bank of India’s monetary policy review on 2 December.

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Published: 27 Nov 2014, 12:41 AM IST
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