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Should RBI cut interest rates?

Business Standard 

Only when core inflation eases but the negative gap between growth and inflation must be bridged by not allowing growth to slip.

Siddhartha SanyalSiddhartha Sanyal
Chief India Economist, Barclays Capital

“It is true that weakening growth is mounting the pressure on RBI to start easing interest rates. However, the current elevated headline and core inflation are clear deterrents against any rapid monetary easing”

Monetary policy in India is gradually turning from its hitherto exclusive focus on curbing inflation to supporting growth. Nevertheless, a reduction in the policy interest rate will possibly have to wait beyond January.

Monetary easing in the coming months is critically contingent on the unfolding inflation trajectory. Headline inflation has indeed eased from over nine per cent in November to less than 7.5 per cent in December. One of the biggest triggers for this has been the sharp fall in food price inflation, which turned negative in some weeks in December for the first time in over five years. But there is not necessarily a big change in food price trends. Food inflation rolled off to an extent in December, in line with the usual seasonal pattern, but base effects from last year’s spike in vegetable prices exaggerated the decline for the inflation optics. Such a fall in food inflation is unlikely to persist for long — even if the index remains constant, food inflation will be nearly six per cent by the middle of February 2012. The spell of unseasonal rain that has taken place in various parts of the country in early-January can potentially complicate matters further on this front. These factors highlight the limited degree of comfort around the outlook for food inflation, even though it is trending negative at the moment.

There has not been any commensurate fall in the other segments of the wholesale price index (WPI) basket so far. Non-food manufacturing inflation – the proxy for “core” inflation for the Reserve Bank of India (RBI) – remains fairly elevated in the 7.5-eight per cent range since February 2011. The elevated level of core inflation remains a key deterrent to any quick and aggressive monetary easing by RBI. In fact, the rise in the price of certain commodities in recent weeks, including chemicals, metals and minerals, is likely to keep RBI extra watchful. There is an element of larger imported inflation in the case of these commodities because they are impacted by the recent weakening of the domestic currency. Also, amid continued large fiscal deficits, RBI feels the need to maintain an extra-vigilant monetary policy. Fiscal slippage in 2011-12 looks imminent. Pressure from the government’s spending – including in rural areas – is likely to stay steady. This pressure on the fiscal front is likely to continue during 2012-13.

In terms of the existing central bank guidance, as recently as in late-October, RBI had publicly termed seven per cent inflation as being clearly above its comfort level to start of the rate cut cycle. RBI had indicated that inflation would have to move at least lower than six per cent before it starts any monetary easing. Growth deterioration since then has possibly surprised policy-makers significantly on the downside. It is true that weakening growth is mounting the pressure on RBI to start easing interest rates. However, the current elevated headline and core inflation are clear deterrents against any rapid monetary easing. I do rule out possibilities of a cut in the repo rate in the upcoming RBI policy next week. Start of repo rate cuts from Q2 2012 is my base case expectation. However, I acknowledge that the chances of the easing cycle starting in March have increased significantly of late.

Given the rising concerns about growth and continued tightness in liquidity, it is felt that RBI will continue to inject liquidity into the system using open market operations (OMOs). A reduction in the cash reserve ratio (CRR) at the January policy meeting appears unlikely, in my view. A cut at this time could be perceived as a dilution of RBI’s inflation-fighting stance, which the central bank would possibly like to avoid at the moment. Indeed, it will be quite a surprise if we see a CRR cut next week after the loads of sound-bytes from key policy-makers virtually negating that possibility for the January policy. OMOs seem to be a better option currently for the central bank to inject and manage money market liquidity. OMOs will have the associated advantage of containing bond yields as well. This would be particularly meaningful given the strong supply pipeline of government papers.

Moses HardingMoses Harding
Head - ALCO and Economic & Market Research IndusInd Bank

“There is need to build investor confidence in the Indian economy to create adequate capacity for expanding supplies. This will need abundant liquidity and a low interest rate regime”

The macroeconomic dynamics have shifted from moderate growth and high inflation to low growth and moderate inflation. There is consensus that headline inflation will fall to 6.75-seven per cent by March 2012 and the growth momentum will slip below seven per cent in FY13. The Reserve Bank of India (RBI) has already shifted its monetary stance from hawkish to neutral in the December 2011 policy review and signalled the end of the rate-hike cycle and its preparedness to shift its stance from anti-inflation to pro-growth. The debate now is on the timing of the reversal process.

While there is comfort on the downtrend in inflation, the ability to sustain it below seven per cent is in doubt. The strong headwinds are from high commodity prices, the weak rupee, supply side concerns and good domestic consumer demand despite tight liquidity and high interest rates. Till inflation falls below six per cent, it is important to bridge the negative gap between growth and inflation by not allowing the growth momentum to slip below seven per cent in FY13. This brings the focus to liquidity and cost of liquidity.

The current situation is worse; the drawdown from the Liquidity Adjustment Facility (LAF) is high, above Rs 1.25 trillion. The system is short of cash by three per cent of net demand and time liabilities (NDTL) against RBI’s comfort level of one per cent for over a month. Tight liquidity and the high call money rate have kept the short-term money market rates at elevated levels while medium- to longer-tenor rates have adjusted to the rate reversal cycle. Clearly, it is important to get the system into adequate liquidity mode at affordable cost as the first measure to shift the monetary stance from anti-inflation to pro-growth.

While RBI continues to have its concerns on whether the downtrend in inflation is sustainable, its firm grip on a hawkish monetary stance can be released soon if the government takes adequate measures to address supply side concerns. At the same time, significant downside pressures on growth cannot be ignored. The support from external capital; liquidity and consumer demand may not be available through FY13. There is a need to build investor confidence in the Indian economy to create adequate capacity for expanding supplies. This will need abundant liquidity and a low interest rate regime. While it is tough to balance growth and inflation dynamics in this complex macroeconomic environment, pressure from the government’s fiscal management is a bother for RBI. The slippage in the fiscal deficit will not only lead to higher dependence on the market but lower flow of public investments into core sectors.

Most economists and analysts prefer delaying the shift into rate reversal mode. While I tend to agree with this on the back of the rupee impact on inflation, it seems now that the rupee has shifted from the risk of extended weakness above 54 into extended gains below 51. There will also be good demand for funds in the next couple of months on the run into financial year-end. There has been higher demand for rupee credit since the start of the euro zone crisis. RBI would need to meet this higher demand for rupee funds through a cash reserve ratio (CRR) cut. But this would not impact the operative policy rate while the system is already short by three per cent of NDTL and the call money rate is trading at the higher end of the LAF corridor (repo rate); a CRR cut of two to three per cent in one shot will be needed to bring the operative policy rate to the lower end (reverse repo rate) to deliver a downward shift of the rate curve by one per cent. It is not prudent to provide a one per cent shift in one shot while it may not be relevant to start the policy reversal process without a change in the operative policy rate. Therefore, action has to be a combination of CRR and rate cuts. RBI has also been vocal in pointing out lag time of three to six months to get the desired effects from policy moves. Given these macroeconomic and market dynamics, there is a strong case to begin the policy reversal cycle now with a “baby step” approach through a 0.5 per cent CRR cut and 0.25 per cent rate cut.

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First Published: Wed, January 18 2012. 00:14 IST