New Delhi: As India, Asia’s third largest economy heads for a winter of deep economic downturn, the prolonged monsoon season that played havoc with farm output and pushed up retail inflation has presented the Reserve Bank of India a dilemma ahead of its monetary policy review in December.

The central bank has to decide whether to further cut its benchmark policy rates to boost investments or to put an end to the rate cut cycle in view of escalating consumer price index (CPI)-based inflation.

To cut or not?

The case for a rate cut is fairly strong with industrial output in September contracting 4.3%, its worst performance since the current series was launched in 2012. Output of capital goods, which indicates investment activity in manufacturing, contracted 20.7% in September against a 6.9% expansion in the period a year ago. However, CPI-based inflation shot up in September to a 14-month high of 3.99%, nearly touching RBI’s medium-term target of 4% on account of a surge in food prices as a prolonged monsoon delayed arrivals into the market. This could bind the hands of central bank in announcing a further rate cut. CPI data for October is due on Wednesday.

“Our forecast for October Consumer Price Inflation was 4% but the continued surge in vegetable prices looks set to push it further up. At present, signals from the economy are conflicting between elevated CPI-based inflation and the muted real sector performance," said Aditi Nayar, principal economist, ICRA Ltd.

Economists see a rate cut in the offing but there are strong factors that could influence the RBI’s decision making to pause monetary easing. One of them is the efficacy of a rate cut in reducing cost of capital on the ground for corporate borrowers as banks have limitations in reducing their lending rates despite the rate cuts. That is because banks will have to reduce deposit rates too if they lower the lending rates, which is difficult considering the high interest rate on small savings with which they compete.

The other factor is the view among experts, which is getting louder by the day, that the need of the hour is a stimulus for boosting consumption rather than a stimulus to investments, which may take longer time to show results.

According to Pronab Sen, former chief statistician of India, investments are a function of investors’ perception of future demand. “Unless there is a visible change in the demand side, it is not going to affect investments at all. You can cut interest rates or corporate tax rate. It is not going to affect investments very much," Sen said, in an interview to CNBC TV18 on Tuesday, adding that the 0.4% contraction in consumer non-durables output in September was indicative of people cutting back on day-to-day consumption as well as of their perception about their ability to consume in future.

“The efficacy of a further cut in policy rates in boosting economic activity is unclear. It is a complicated scenario, but there seems to be a higher likelihood of a rate cut. The second quarter GDP numbers expected later this month will give further clarity on the likely rate actions," said Nayar. Second quarter GDP numbers are widely believed to reflect the stress in industrial output, which contracted in September. The average industrial output in the second quarter had shown a 0.36% contraction compared with a close to 3% expansion in the first quarter, during which the economy expanded by 5%.

Quantum of rate cut

RBI governor Shaktikanta Das has moved away from the precedent of revising rates in tranches of 25 basis points, arguing for more flexibility in rate setting which could help the central bank in making the most appropriate response in a volatile situation. RBI had cut the rate by an irregular 35 basis points in August, the fourth so far this year. It had so far cut rates five times this year to stimulate growth, taking the cumulative reduction to 135 basis points to 5.15% at present. Das, in a speech in April, had argued that rate revisions could be in terms of 10 basis points or 35 basis points when warranted. At its last monetary policy review, the central bank cut its GDP growth estimates to 6.1% from 6.9% for this fiscal.

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