Cut That Rate!

More on the grand Indian attempt to rekindle those "animal spirits". Here are some views held by economists monitoring the RBI's monetary policy stance (which incidentally looks like this):

M3 is the y-o-y growth percentage of broad money. Both the rates are on the right axis while the WPI % yoy (This is because WPI inflation (and non-food manufactured goods component) is significantly more sensitive to international commodity prices than the typical consumer price index (CPI)-based inflation)  and M3 are on the left axis.

RGE analysis and forecasts "does not see the RBI cutting rates again until Q1 2013". Furthermore, "the decision by the RBI to go for a 50 bps rate cut in April was in anticipation of an imminent correction in diesel prices" that is only coming along now. Changes in the external scenario (impact of QE3 on commodity prices etc.) further contribute to the RBI's hawkish stance whilst simultaneously being mindful of over-tight liquidity conditions. 

Rajiv Malik, of CLSA thinks that, "the RBI was correct in leaving the repo rate unchanged, as it had already anticipated some action from the government ...A rate cut today would have made the RBI a laughing stock..."

Victor Mallet reported for the FT a week ago that the diesel price increase will ultimately not reduce the fuel bill all that much and he quotes a senior government official as saying, "what's creating the space for doing these things is a growing sense of crisis. The crisis helps you override gridlock, vested interests...there's a sense of urgency." 

That's good news, but we've known that all along!  How many crises must we learn from in hindsight? The Indian parliament may be a mess but that's no excuse to divert attention from it! This is evidenced by two officials from the FICCI who felt that the central bank, in restricting M3, would be constraining economic activity and thereby indirectly nudge the rate up while trying to prevent a depreciation of the rupee.

Meanwhile, outgoing CEA Mr. Basu believes that the right stance has been taken with inflation being "uncomfortably high". As growth can be expected to be feeble at best, "the onus is on the government to bring about changes."

DBS Group research a few months ago opined that, "rate cuts are premature and (we) have pencilled in cuts only because the central bank and the government appear to worry more about slowing growth than about inflation." It goes on further to state that while conventionally a central bank plays ahead of the curve by easing conditions on the back of under-potential growth, India's economy is "undergoing structural changes", making it harder to "judge with reasonable confidence that the output gap is negative".

Lastly, Saajid Chinoy (a JP Morgan economist) stated that by sticking to their stance, the RBI had "increased the sense of urgency in Delhi". He cited scant evidence that "a small cut in interest rates would stimulate economic demand". 

My sense is that any loosening may well be too premature and a bit too arrogant. Hoping that lowering rates will brighten business sentiment and investment without adversely affecting price levels goes beyond being optimistic. The bottom line is that the RBI has a paramount duty of maintaining price stability and ensuring an adequate flow of credit to productive sectors as evidenced and restated in the Mid-Quarter Monetary Policy Review. 

No one's denying that monetary policy has a crucial role in reviving growth but it must be used judiciously and not as a tool to try and account (read: cover up) for the paralysis in the centre and the structural deficiencies in areas of the real economy. 

There's a consensus that, the RBI needs to be internally consistent, credible (like any central bank) and above all, immune to immense market pressure. India's growth has suffered, its currency taken a beating and there are glaring weaknesses in some broader underlying macro fundamentals. 

Global headwinds and downside risks disrupt the scope of policy change but the direction must be made clear - the RBI cannot and must not underestimate the inflationary effects on a fragile economy suspect to external developments.