Eventually rates have to fall, but when?

Eventually rates have to fall, but when?

The Reserve Bank of India (RBI) has been pointing out that high interest rates are not the only reason for the growth slowdown. We agree, but in our view, while lower interest rates may not be sufficient, they are a necessary pre-condition for a growth turnaround. As such, if growth is to revive, interest rates have to come down. The question is when.

Rising minimum support prices (MSPs) are compounding concerns about the structural uptrend in India’s food inflation. The government’s decision to hike MSPs by 15-50% in FY13 will have a cascading effect on overall inflation, not only because it will raise the floor prices for food, but also because of the impact of high food prices on inflation expectations.

True, core inflation, which excludes food and fuel, has moderated. But in a country like India where food and fuel account for 60% of consumer expenditures, focusing only on core inflation can lead to big policy mistakes.

We doubt that the RBI can tame structural food inflation with higher interest rates, but if it loosens policy, overall inflation, which is already above the tolerance zone, can shoot up. Moreover, even though core inflation has moderated, its momentum is again picking up, and at 4.9%, it remains above the medium-term average of 4.5%.

The other argument in favour of rate cuts stems from the fact that India is a supply-constrained economy and needs investment, which cannot recover unless interest rates are cut. By delaying rate cuts, the RBI is holding back investment and only creating more inflation. We view this argument as flawed, because even with a rate cut, investment will not thrive in an environment of high inflation, large fiscal deficits and frustratingly slow progress on structural reforms. The government has yet to bite the bullet on implementing the long-pending fuel price increases, let alone hiking foreign direct investment limit in the non-controversial aviation sector.

To be fair, the economy has lost considerable momentum: industrial output growth is grinding to a halt; there is no sign of an improving investment pipeline, and exports are contracting. However, this is not the time for the RBI to panic. The objective of slowing demand through monetary tightening was to tame inflation. This objective has yet to be attained. As such, the space for rate cut exists, but is still limited.

A combination of government policy action and low inflation readings could prompt the RBI to deliver token rate cuts over the course of the fiscal year, but this will not be enough for growth. Eventually, rates have to come down much more. A muddle-through global scenario where central banks continue quantitative easing and keep commodity prices elevated would not be ideal for India. India’s economic momentum has slowed so significantly, that a much more aggressive policy easing is necessary to have a material impact on growth.

However, such an aggressive easing will have to go hand-in-hand with a lower fiscal deficit and, more importantly, lower inflation. Either a collapse in global commodity prices will present the RBI with such an opportunity or slow growth should eventually bring inflation down. The next few months will show us the way, but don’t hold your breath.

Sonal Varma is executive director and India economist, Nomura Financial Advisory & Securities India Pvt. Ltd