RBI's monetary response

Questions over the magnitude of the rate cut

Four days after the Union Budget was presented and a day after the new monetary policy framework was announced, the Reserve Bank of India (RBI) has responded with its second out-of-cycle policy rate cut. As regards the Budget, the RBI has expressed some concern about the deviation from the Fiscal Responsibility and Budget Management (FRBM) road map. This would have put the fiscal deficit at 3.6 per cent of gross domestic product, or GDP, whereas the government eventually settled at 3.9 per cent. Observers can only conclude that the assurance by the finance minister that the entire overshoot would be spent on infrastructure apparently offsets any misgivings the RBI might have had about slippages. While normally government spending might be considered inflationary, the monetary policy statement suggests that the government's high priority for spending on infrastructure might be critical to easing supply constraints that have exacerbated inflationary pressures. It further notes that the larger volume of transfers to states, mandated by the 14th Finance Commission, may have contributed to a higher fiscal deficit at the central level, but could well reduce it at the state level. This means that aggregate fiscal consolidation will remain on track.

As for the agreement between the RBI and the government on a new monetary policy framework, the former is clearly confident that this will remove both ambiguity about the goals of monetary policy and the pressure that typically emanates from the government to favour growth over inflation control. With this added room to manoeuvre, it perhaps thinks it can be a little less conservative than otherwise, using whatever space there is to demonstrate its compliance with the target range laid out in the framework. With headline consumer inflation at around five per cent, below the immediate target of six per cent, there is room to reduce the repo rate. Of course, the policy statement does the usual job of highlighting inflationary risks, but these risks have been in play for some time now and do not alter the baseline scenario significantly. International developments may have been the crucial extra dimension. The RBI had begun to express concern that the continuing interest-rate differential between India and the rest of the world was leading to what the governor has called an "avalanche" of fund flows.

However, the timing and magnitude of the cut do raise some concerns. On timing, this is the second cut in a row done outside the schedule. Of course, the freedom and flexibility to take out-of-cycle action is necessary, but this is typically used in a crisis-management situation. Much more of this and markets will begin each day looking for rate actions! Schedules and predictability do have their merits. On the magnitude, since the RBI is explicitly saying that it assesses economic conditions as being weak, given the space that exists, it might be asked why it isn't doing more. If the intent is to stimulate demand, the current inflationary scenario certainly does not warrant a slow-and-steady approach. Of course, the counter-argument is that interest rates are not the binding constraint on investment; infrastructure and regulatory bottlenecks do need to be addressed to get the full benefit of large declines in interest rates.