Need pre-emptive action

As the Reserve Bank of India (RBI) prepares for tomorrow's announcement on its quarterly monetary and credit policy, the dramatic events of last week must surely weigh on Governor Venugopal Reddy's mind. Collapsing equity markets around the world and the virtual certainty of a similar plunge in US markets last Tuesday prompted the US Federal Reserve to make a 75 basis point cut in its benchmark federal funds rate, the first of this magnitude in over 20 years. The Fed's action appears to have worked, at least for now, but perhaps to a greater degree in Asia than in the US, as markets in this region, including India, bounced back towards the end of the week. The reason for investor optimism is twofold: with the Fed's actions, the anticipated recession in the US could turn out to be a relatively mild one, and the policy response to the current situation is quite strong, with both monetary and fiscal instruments coming into play.

From a purely domestic perspective, there would be a reasonably strong case for maintaining the status quo on interest rates in Tuesday's announcement. The economy is showing some signs of moderating, reflected in the volatile pattern that the index of industrial production (IIP) has shown in the last five months. While the average growth rate has not declined by much, alternate months have seen rather subdued growth rates, with the latest (November) numbers coming in at barely 5 per cent, amongst the lowest in the last four years. The slowdown is most severe in sectors such as transportation equipment and consumer durables, which are sensitive to interest rates. Despite this, overall GDP growth is comfortable, with agriculture having responded favourably to the good monsoons and services maintaining momentum. While growth will be slower in 2007-08 than in the previous year, it should still come in around 8.5 per cent, which is consistent with the RBI's perceptions of a sustainable trend. On the inflation front, while the numbers hover below 4 per cent, helped by the favourable scenario in food prices, the wide gap between international and domestic prices of petroleum products will eventually have to be bridged. Even after the recent softening of global prices to below $90/barrel and the appreciation in the rupee, the inflationary impact of the correction could take the rate close to the tolerance level of 5 per cent, while lower food inflation cannot be taken for granted. This is the strongest argument against lowering rates in the impending announcement, with the increasing likelihood of a cut later in the year as the deceleration in the growth rate becomes more pronounced and the balance shifts in its favour.

But, the policy announcement cannot be made in a vacuum. Significant and prolonged market volatility can have an impact on the real sector, impacting both investment and consumption spending. If an already weakening macro-economic scenario is further threatened by financial instability, cutting interest rates now rather than waiting for the next quarter could help to stabilise both. Since the choice is one of timing rather than direction, Dr Reddy should have no hesitation in making the cut now. While the inflation risk remains significant, the growth risk has become a lot larger in the past few days.