Tightening reversal unlikely to spur growth or lower rates

A section of the market believes RBI should hold rates as negative real rates will hurt savings and investment

The rupee's stability has again triggered talk of a reversal of July's tightening measures. Most economists say the marginal standing facility (MSF) needs to be cut by another 25 basis points to 8.75 per cent and the repo rate raised by 25 basis points to 7.75 per cent, to normalise the monetary policy environment.

However, narrowing the gap between the MSF and the repo rates to 100 basis points is unlikely to reverse macro imbalances. Some economists believe the Reserve Bank of India (RBI) should retain MSF rates at the current level, if not higher, as real interest rates have turned negative for savers if one looks at the consumer price index (CPI). The currency has stabilised more due to global factors than local ones.

Other than the currency, macros are still looking stressed. Estimates of a modest 4.5 per cent growth in GDP appear to be at risk. The bumper crop this year could push up agriculture growth to over three per cent levels, but this growth might not tame inflation as bulk of the CPI inflation is driven by fruits and vegetables.

Tirthankar Patnaik of Religare Institutional Research believes the modest hike in support prices of rabi crops won't help much either, as they account for 1.87 per cent of the wholesale price index (WPI) basket and four-five per cent of the CPI basket. While the impact on wholesale inflation would be negligible, that on CPI would likely be 50 basis points, based on September 2013 prices, he says. He does not rule out a rate hike in December.

Over the past four years, the divergence between CPI and WPI has increased and yet it's the WPI that policymakers use to assess inflationary pressures. Given that the savings rate has been falling more sharply than the investment, Morgan Stanley's Chetan Ahya and Upasana Chachra believe the focus of policy makers should have been on the real rate for savers, as a significant part of WPI represents intermediate/input prices and not final consumption product prices.

RBI is focused on lowering rates by looking at the WPI, though what has hit savings is a very high CPI. As a result, the central bank has not been able to trigger a revival in investments despite rate cuts. For four years, real interest rates have remained negative for savers. Low real rates are good for growth but not when real rates are depressed due to high inflation. According to Morgan Stanley, this unpleasant mix can be avoided with an overall anti-inflationary thrust in monetary policy, which accommodates growth needs only when inflation stays under the six per cent threshold.