The value of consistency

RBI must adhere to a course once selected

On January 15, the Reserve Bank of India (RBI) surprised many people by cutting the repo rate by 25 basis points. On reflection, the action should perhaps not have been that unexpected. Governor Raghuram Rajan's message, as he chose to maintain the status quo over the past few policy announcements, despite a loud clamour to cut rates, was that he was worried that an inflation bounce-back in December might make a rate cut seem a little premature. As things turned out, inflation did nose up last month, but barely. If that was the only reason for the RBI to hold back, it was logical to act as soon as it was clear that the chances of an inflation bounce-back were remote. And so it did. The question, of course, is: what next? Already, expectations are shaping up on both sides of the fence about what the RBI might do in its next scheduled review on February 3. Some argue that the January 15 action was, in fact, simply the advancement of a cut that would have been made on February 3 and, therefore, it is unlikely to be repeated. Others feel that the cut was actually the beginning of a series and, once begun, the process has to be persisted with and taken to its logical conclusion. The repo rate has to be brought down to a level consistent with the expected path of consumer inflation.

The policy statement was itself somewhat ambiguous on this. By emphasising the value that the RBI places on credible fiscal consolidation, it created the impression that it would now wait for the Budget of February 28 before it decided to take any further action. On the other hand, since it has emphasised that its actions will be consistent with the overall inflationary scenario and virtually everything points to inflation remaining moderate, there is clearly room and rationale for continuing with the rate cuts regardless of the Budget numbers. In any case, the signals emanating from the ministry of finance are that it is completely committed to the fiscal consolidation path, there isn't much of a case for waiting.

The bottom line is that the principle of consistency must be adhered to in the announcement on February 3. A course, once selected, must be adhered to. The positive impact of the surprise of January 15 can be quickly neutralised by what would be seen as a flip-flop, if the status quo is maintained on February 3. This would leave the markets guessing about the motivations that are driving policy. For instance, was the January 15 action taken more in response to pressure than on the basis of conviction that the inflation trajectory had changed for the better? If the intent of interest rate reductions is indeed to stimulate demand for both consumer and investment goods, people and businesses need to have some assurance about where interest rates are likely to settle and how quickly they will get there. One could argue, then, that the best response to the recent change in inflation dynamics would be a sharp reduction in rates. However, that would require a lot more certainty about the macroeconomic situation than anyone can reasonably have. The prudent course would be a series of reductions, always leaving room for a pause if circumstances so warrant.