Addressing the slowdown

The challenge is growth, RBI must cut rates next week

The Reserve Bank of India’s next review of monetary policy is scheduled for Tuesday, when it will announce whether it is cutting rates or holding them steady. This comes after a sequence of 13 increases, during which the central bank raised the policy rate from 3.25 per cent to 8.5 per cent. Last month, as signs that the economy was slowing became unmistakable, the RBI indicated a shift in its stance, saying that future changes in the policy rate would likely be downwards. Yet the timing of this much-anticipated downward shift is as yet unknown. It would be a mistake to leave it for later.

It is of course evident that the RBI continues to be concerned about inflationary pressure in the economy. Headline inflation, which had been driven up by a combination of factors – including increases in the prices of food products and oil, and the sharp decline of the rupee against the dollar – has moderated sharply. This movement has been thanks to the fact that food inflation has come down to near zero. However, inflation hawks point out that the manufacturing sector, in particular, is continuing to show high inflation. That is of course true. But there is little doubt that, as growth slows, India is moving towards a deflationary environment. The Reserve Bank must not be caught on the wrong foot; monetary policy must anticipate such changes. When rates were rising, the question of the lag with which monetary policy works was bruited about. Because of the weakness of many of the links between the financial and real sectors in India, monetary policy’s impact on prices and output is not as immediate as it is in more developed economies. The RBI is not making policy for January; it is making policy for several months down the line. Its own estimate of the the lag time is between three and six months. It will need to sensibly extrapolate recent data to come to a conclusion as to what it should do.

Recent data, of course, paint a worrying picture. The recovery of industrial production in November 2011 – after a poor October – was patchy, with capital and intermediate goods continuing to show no growth or an absolute decline. GDP growth estimates keep being revised downward, and it is possible that 2011-12 will end up being the worst performing since the drought year of 2002-03. The outlook for next year is cloudy, because the external environment continues to be unfavourable and indeed unpredictable. Businessmen’s wary calculations of the future have to be jogged to change, and reduced cost of capital is always a trigger for an uptick in investment, which is what the system needs. The time has come for Mint Road to signal unambiguously that restoring growth has become its priority. On January 24, the RBI should announce that it is cutting the repo rate by 25 if not 50 basis points.