Cause for a pause

RBI would be justified in opting for continuity

Reserve Bank of India (RBI) Governor Urjit Patel's maiden monetary policy on October 4 is keenly awaited for two reasons. One, this is the first time that the final decision will be taken by a committee. Of particular interest will be the manner in which the decision is reached - whether there is consensus or a division of opinion and if so, of what nature. Two, there is, rather predictably, a buzz about an interest rate cut. On its part, the government has repeatedly held that the economy needs a further easing of monetary policy. It is true that retail inflation, especially food inflation, has fallen sharply. After rising to a 23-month high in July, retail inflation dropped to 5.07 per cent in August. In particular, the consumer food price index-based inflation fell from 8.35 per cent in July to 5.91 per cent in August. The RBI has maintained the status quo since April after food prices had risen sharply.

So, going forward, there are two key reasons why the monetary policy committee (MPC) may choose to cut the interest rate, possibly by 25 basis points. One, food inflation is expected to fall consistently in the months ahead and thereby bring overall retail inflation well within the four-per cent (plus/minus two per cent) band mandated under the Monetary Policy Committee (MPC) regime. Two, notwithstanding the tag of the fastest growing major economy in the world, the Indian economy is gasping for private investment. The provisional estimates for the first quarter of 2016-17 showed that the gross domestic product (GDP) had grown by 7.1 per cent - the slowest in five quarters - as against 7.5 per cent in Q1 FY16. In both the quarters, the gross fixed capital formation has contracted, by 3.1 per cent and 1.9 per cent, respectively. The index of industrial production for July, too, contracted by 2.4 per cent - much against expectations and leading to renewed calls for a rate cut.

However, compelling these key factors may be, Mr Patel might still be justified if he and the MPC decide to opt for continuity and adopt a wait and watch approach on Tuesday. There are several reasons why the status quo is merited. First, the US Federal Reserve has deferred a possible rate hike to December. The Fed's decision, in turn, might well be affected by the outcome of the US presidential election. Two, according to the latest round (June) of the RBI's Households' Survey, inflation expectations for the next three-month, as well as for the next one-year, period have risen. Then there is the expected forex volatility and associated fall in liquidity as foreign currency non-resident (FCNR) deposits worth $26 billion are redeemed in October. Lastly - and this is at the heart of the matter - is the weak monetary policy transmission. In any case, the RBI has been relying more on liquidity management than rate cuts for its policy transmission. The latest uncertainty on the Indo-Pak border could further sway opinion in favour of the status quo on interest rates. It is highly unlikely, therefore, that Mr Patel will risk policy continuity and credibility just to earn a few brownie points from those who are clamouring for a rate cut. In any case, he can easily wait for the next consumer price index figures and go for an off-policy rate cut, if the situation so warrants.