Should RBI cut rates after sharp contraction in IIP?

Even some economists believe Governor Rajan is late in cutting rates, he has reasons to be careful

It hasn't been a good week for the markets. The risk-off trade, which has dragged the benchmark indices down, may continue next week too, as industrial output for the month of October has contracted by a shocking 4.2% and the central bank isn't in the mood to cut rates even though retail inflation continued to soften to 4.38% in November.

The divergent trends are expected to create more confusion among economists, who are anyway divided over Governor Rajan's inflation-targeting approach to monetary policy. After the weak industrial output, the clamour for rate cuts will reach fever pitch. And in the process, strategists and equity experts will ignore the fact that HSBC Manufacturing PMI hit a 21-month high in November to 53.3. In October, Manufacturing PMI was at 51.6, clearly suggesting an uptick in industrial activity. However, IIP data suggests that manufacturing has declined by 7.6% in October.

The market and a handful of economists have been asking for a stimulus in the form of a rate cut ever since CPI started softening earlier this year. Many believe that the RBI is already too late when it comes to acting on lowering benchmark rates, as they believe that by targeting inflation alone, RBI Governor Raghuram Rajan is ignoring growth. So is RBI Governor Raghuram Rajan behind the curve or is he plain prudent?

Those arguing for rate cuts believe that the real interest rates have been positive since January and that now they are well above the RBI's 150-200 basis points territory. But those in favour of a pro-longed pause believe once real interest rates are calculated by factoring in RBI's policy rates and the retail inflation, then the rates have turned positive only in the last few months.

Samiran Chakraborty, economist at Standard Chartered Bank, says "The governor has adopted an inflation targeting approach to monetary policy and he is acting on that premise. After so many years of high retail prices, just two months of low inflation might not be able to convince the central bank that the decline is sustainable. The real policy rates have turned positive only in the last two months and the RBI Governor is expected to wait for another couple of months to see a trend developing and also see how the government manages the fiscal side. Therefore, we have a call for a rate cut in February."

HSBC Global Research too has a similar view and it says in a note: "If the RBI is able to hold on to rates at this crucial juncture, it should get a clearer sense of whether the current softening in commodity prices is likely to persist. It should also allow some more time for the recent fall in prices to feed into inflation expectations. These factors are critical if the RBI wants to meet its target of 6% CPI inflation by January 2016, and more importantly, remove excess inflation that has plagued the economy."