A logical response

After RBI's rate cut, Budget must show fiscal tightening

When the inflation numbers for December were published on January 12 and 14, they did show slightly higher inflation rates than in November. But they also delivered a positive surprise. The magnitude of the increase was clearly much smaller than many people, particularly the Reserve Bank of India (RBI), had expected. Since the extent of the turnaround had been advanced by the RBI as the main reason for it maintaining the status quo on policy rates, it was only reasonable to expect a quick response. And so it turned out, with the benchmark repo rate being reduced by 25 basis points to 7.75 per cent. The rationale provided by the RBI was exactly in line with this reasoning. The moderation in the inflationary momentum has been more significant than anticipated and this has largely offset the unfavourable base effects. More importantly, the policy statement underscored the fact that the latest inflationary expectations survey showed a significant decline in this parameter, with household expectations having declined from persistently being in double digits to single digits. Since a stated objective of monetary policy is to rein in expectations, this development strongly reinforces the argument in favour of cutting rates.

Since the rate cut has now been done, the next question is: by how much more and how quickly? This is a fundamental dilemma that policymakers face. If providing a stimulus to growth is the objective now, that would be best served by moving rates as quickly as possible to the bottom. If the reductions are slow and measured, there is the risk that both consumers and businesses will delay spending decisions in anticipation of further cuts. Floating-rate schemes neutralise this risk somewhat, but not entirely. On the other hand, if the reduction is sharp and quick, an adverse inflationary shock, such as a weak monsoon or a sharp increase in oil prices, would require a reversal, upsetting people's spending plans. "Keeping your powder dry" is a popular, and wise, aphorism amongst central bankers. A middle path clearly has to be found. As far as the bottom is concerned, a rule of thumb would suggest that the RBI would like to maintain the real repo rate in the range of 1-1.5 per cent. With the latest rate cut, it is 2.75 per cent, indicating room for further cuts to the tune of 1.25-1.75 per cent, assuming that retail inflation remains steady at around five per cent. On a two-monthly cycle, this could be achieved in one year with six reductions of 25 basis points each, or in six months with three reductions of 50 basis points each.

The statement itself gives some pointers to the RBI's thinking on the pace of reduction. It emphasises the importance of credible fiscal management as a pre-condition for sustained reductions in the policy rate. The Union Budget for 2015-16 will then be a milestone around which the magnitude of the next move will presumably be decided. It also refers to steps taken by the government to ease supply constraints. Significant actions on this front, say, in relation to infrastructure, may well induce more rapid easing. Finally, although the monsoon was not specifically mentioned, keeping some powder dry to deal with a bad one would be prudent.