The deep cut in interest rates that the Reserve Bank of India (RBI) announced on Saturday did not come as a surprise. It was widely anticipated, as the economy is slowing and wholesale price inflation is falling as a result of the collapse of global commodity prices. Consumer prices are still growing at a double-digit rate, though they, too, may come down next year. The cut in fuel prices will also ease the burden on households.

Illustration: Jayachandran / Mint

The first set of measures tried to deal with a liquidity squeeze: The short-term money market was starved of funds and credit flow in the economy was impaired. Around Rs3 trillion of primary liquidity was pumped in by the central bank. There were elements of firefighting in these policies. And it is clear that the fires have been doused, at least for now. Average call money rates have dropped back to levels that are consistent with the central bank’s short-term interest rate corridor. The so-called liquidity adjustment facility window that RBI uses to manage short-term interest rates is now being typically used to soak up excess liquidity.

The most recent rate cut tries to attack another problem: the growth slowdown. RBI governor D. Subbarao was refreshingly blunt in his Saturday statement that accompanied the rate cuts: “The fundamentals of our economy continue to be strong. Once the crisis is behind us and calm and confidence are restored in the global markets, economic activity in India will recover sharply. But a period of painful adjustment is inevitable."

The pace at which domestic and global economic growth has decelerated since October is ample proof that Subbarao’s warning of a painful adjustment is not an exercise in hyperbole. There are two elements to this slowdown. First, there is the collapse of aggregate demand around the world; further damage needs to be prevented with the usual Keynesian mix of lower interest rates and higher fiscal deficits, at least in countries that have strong public finances. Second, there is a different sort of problem that arises from irrational exuberance and high leverage in certain sectors such as real estate and aviation. Here, the Austrian belief that a recession should be an opportunity to restructure or kill fundamentally uncompetitive and over-invested businesses should be the frame of reference. The first round of cuts did their job: Liquidity has eased in India. It is hard to believe that the latest cuts will win the battle against the slowdown with equal ease.

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