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Crucial Meeting
The next Monetary Policy meeting of the Reserve Bank of India, RBI, scheduled to be held on 29th September, promises to be a crucial one. It is not possible to know beforehand if sparks will fly. What is certain is that any decision taken will impact the Indian economy, in important ways. Though the RBI has cut interest rates by 75 basis points this year, expectations that it will cut again runs high. The RBI Governor, Raghuram Rajan, has repeatedly asserted that fighting inflation would be his top priority.
Economic environment
The reason for this is quite simple. While fiscal policy (made by the executive/Finance Ministry) plays an important part in controlling inflation, interest rates are an equally important signal to market players about the state of play in the economy.
A big worry for the RBI is the failure of the monsoon. The main rainy season is almost over with most states reporting deficits. Earlier, Rajan had said that he would closely watch the progress of the monsoon and its impact on agriculture and food prices before making a decision. Sky rocketing onion prices is but one example of why this worries Rajan.
The U.S. Federal Reserve held its fire last week and kept rates on hold. But sooner than later as the American economy continues to grow, rates are likely to go up. Rising slowly, they are expected to reach an equilibrium rate of about 3.5% sometime in 2018. To make things murkier, currently the international economic system is in turmoil, whether it is in Greece, or in the stream of bad news emanating from countries like China and Brazil.
Is It Disinflation?
Raghuram Rajan has made two significant statements. He has said that the real boost to the economy should be delivered by the reforms already promised by the government, rather than by mere rate cuts alone. The other is that he would have to take into account the interests of savers, who naturally would prefer higher rates, versus borrowers who would prefer lower rates. In a capital short country like India, incentives to save can never be overemphasized. "For us at RBI, the key task is to keep inflation low - not just today but well into the future, so that we get nominal modest rates that satisfy not just very vocal borrowers but also the silent saver." says Rajan. (Business Standard September 19, 2015)
Further, Rajan pointed to the cautionary tale of Brazil's boom and bust. The Brazilian economy was chugging along nicely when political pressures were mounted on its central bank for more and more rate cuts, which the bank, under duress, obliged. According to Rajan this fuelled a credit spree that saddled customers with large debts that they are now finding difficult to pay off, and stalling growth. "Brazil tried to grow too fast. They were forced to reduce credit cost. The takeaway lesson is, it is possible to grow fast with stimulus and rate cuts, only to pay the price later through high inflation," he said, adding, "Brazil might have overspent and China might have over-invested. We need the understanding and cooperation of the business community, not impatience and pressure for quick impossible fixes."
Though wholesale prices have been in negative territory for nearly nine months now and consumer prices fell to just 3.75% last month, Rajan feels that there may be underlying inflationary pressures. He worries that the reason for lower inflation numbers may be due to base effect. That is, since inflation was high till the same period of the previous year, inflation numbers now shows up as low, rather than being actually or intrinsically low. Another factor is the decline in oil prices which has contributed disproportionately to the fall in the overall price levels. This apparent slowing of inflation could well hide higher prices in other sectors. Thus Rajan seems to feel that while price increases are slowing, inflation as such has not yet been tamed. Rajan is convinced that we are in a situation of disinflation, or a slower pace of inflation. Analysts say that while prices may continue to moderate, no one really expects prices to actually fall from current levels.
Or Deflation?
Deflation means reduction in prices, fewer jobs and smaller incomes. Generally economies go through a deflationary phase just before a major depression. Arvind Subramaniam, the government's Chief Economic Advisor, fears that India might be entering into a deflationary cycle.
"Price wise, the Indian economy appears to be in or close to deflation territory and are away from inflation territory," he says. In August, Wholesale Price Index, WPI,based inflation was in negative territory for the 10th straight month, at a historic low of -4.95 percent.
"Market factors at the moment do favour lowering of rates... time is ripe for RBI to take the decision," said Bank of Baroda MD & Chief Executive Officer. (Economic Times, 19 Sep, 2015)
The Prognosis
The RBI's target is 6% inflation by January next year. Some analysts feel that this is too high a target. There is also a spread of 6% to 7% between the WPI and the CPI, which the RBI should take note of.
Another point is the continued pause by the U.S. Federal Reserve. The common sense wisdom is that other global currencies, including the rupee would take a beating if and when the Fed ups its rate. Reducing interest rates when the currency is depreciating would simply not be possible. In fact if the rupee falls too much, rates might even have to be raised.
Given this background, the RBI will likely cut rates by another 25 basis points. This will certainly boost the economy to some extent and may reduce interest rates for borrowers. Minister of State for Finance Jayant Sinha said, "We are in a favourable environment now. Obviously, all of these have to be balanced and RBI has to take its decisions."
One factor that is quite clear is that our RBI Governor is not looking at just the headline inflation number in deciding timing and quantum of interest rate cuts. He is certainly looking at a whole range of domestic and international factors, and is clearly looking beyond a single rate cut of 25 bps, in making well balanced and forward looking decisions on steering monetary policy in these challenging times.
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