RBI's cautiously optimistic approach

There could be a surge in 'catch-up' buying activity if the apex bank cuts rates in January

Cheap money helps drive growth by making investment easier and helping to stimulate consumption demand. In a standard boom-bust cycle, there is a point when interest rates turn negative, as the cost of borrowing drops below prevailing inflation.

This is a sweet spot. Growth accelerates. The stock market often sees sustained rallies during such periods. Debt funds, banks and other lenders gain in many ways. Debt portfolios with positive returns rise in value. The lenders' cost of borrowing drops and credit offtake rises. Yields fall on treasury bills, leading to capital gains. Other businesses gain because demand rises as the cost of financing drops. Governments gain because deficits can be financed cheaper. The opposite situation - positive interest rates, with a big spread over inflation - is bad for growth. The positive aspect of high real interest rates is that these mitigate inflation. India has positive interest rates and lower inflation is leading to wider spreads. Inflation has fallen. The year-on-year change for the wholesale price index (WPI) for August was 3.74 per cent over August 2013. That's quite a dip from July, when YoY was at 5.2 per cent. The Consumer Price Index (CPI ) YoY was 7.8 per cent in August, down from 8.6 per cent in July 2014. Debt instruments offer big yields. Treasury Bills are at nominal yields of over eight per cent. Banks are offering fixed deposit rates of nine per cent. Commercial rates are in double digits.

The inflation trend is in line with the Reserve Bank of India (RBI)'s target of CPI YoY at 8 per cent or less in January 2015. RBI also runs household (HH) surveys to gauge inflation expectations. The HH expectations are very high. Median HH expectations for current, three-month and one-year ahead inflation in April-June were 13.3 per cent, 14 per cent and 15 per cent, respectively, against 13.3 per cent, 12.9 per cent and 15.3 per cent in the previous (January-March) quarter.

HH expectations are often strongly correlated to actuals and drive wage negotiations and spending patterns. So, a high HH is worrying. One possible explanation: Public memory is proverbially short. Given persistent high inflation for two years, maybe high expectations have become hard-wired. RBI has kept rates unchanged. The problem is that two key areas that cause high inflation are not influenced by rupee interest rates. India's inflation is heavily driven by food and by global energy prices. Food and fuel have a combined 35 per cent weight in WPI, and about 62 per cent combined weight in CPI (the CPI is calculated on the basis of retail prices). High global crude oil prices affect the energy-deficient economy. As of now, crude oil prices are trending down and so is coal.

India's food supply chain has multiple distortions and rigidities. Farm produce can only be sold to cartels (the Agricultural Produce Market Committees or APMCs). Transport links are deficient. Much food (up to 40 per cent of fruit) is spoilt due to a lack of cold chains and processing facilities. As a result, food prices are often high, even if there's surplus production. Changing this would mean repealing laws that empower APMCs. A review of the government's procurement programmes is also required. Good roads, stable power and equipment are needed to develop cold chains and to move food quickly to market. Therefore, RBI cannot do much about food and fuel. But the monetary stance should push down core inflation (minus food and fuel). Core WPI and CPI were at 3.5 per cent and 6.9 per cent, respectively, in August. Both should drop. Differences between CPI and WPI should also narrow.

The central bank's latest review is being interpreted by some investors as a promise to cut rates if the eight per cent CPI target is hit in January 2015. RBI is looking beyond, at the six per cent CPI target for January 2016. It is holding GDP growth projections for 2014-15 at 5.5 per cent. The bank is cautiously optimistic about growth resurgence. It hopes stalled projects will restart, with relief for public sector banks with stressed balance sheets and infrastructure loan dues. RBI also implied that GDP growth might slow in Q3 and pick up in Q4. There could be a surge in equity buying in January 2015 if the RBI does cut rates at that point. A substantial minority opinion believes there will be no policy rate cuts till April 2015. A cut would be a positive surprise for that section of the market and it might induce "catch-up" buying.