Not till we are confident that inflation will stay under control but there is a need to manage the growth-inflation balance too
Chief Economist, CARE Ratings
“While inflation is less of a worry than it was in, say, October 2011, monetary policy should take a futuristic view of expected inflation before releasing the pressure”
The present economic environment has a proclivity towards the penumbra of the economic canvas with the latest GDP and index of industrial production (IIP) numbers not really telling a happy story. While the industrial growth numbers will probably improve, we are still talking of a sub-seven per cent GDP growth rate. The worst is possibly behind us and, therefore, there is a case for discussing seriously what the Reserve Bank of India (RBI) should be doing when it announces its policy on March 15.
Should interest rates be lowered? On the face of it, there could be a case for doing so since growth in investment in particular has slowed — capital formation has come down to 30 per cent in Q3 FY12 from a high of 34 per cent in Q2 FY11. Evidently, few companies are borrowing expensive funds since profitability has been lowered on account of high interest cost. But the main purpose for RBI to raise interest rates was to address inflation. Although inflation has moved downwards from the double-digit level to a more tolerable 6.5 per cent in January, there are two considerations.
First, has inflation come to stay at a lower level? The answer is probably a shoulder shrug because prices are still high in all the three segments and it is more probable that the high base effect has statistically brought the numbers down. In fact, month-on-month indices have continued to show an increase for manufactured products, which broadly is the core inflation basket. Therefore, while inflation is less of a worry than it was in, say, October 2011, monetary policy should take a futuristic view of expected inflation before releasing the pressure.
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This leads to the second consideration: are prices going to come down next year? The answer, again, is one of ambivalence because the oil crisis on account of Iran can escalate to greater levels and given that the potential is to add one to 1.5 per cent to inflation, RBI needs to tarry. Also, it has to take into consideration the policy stance of the Budget towards fuel subsidy before taking a call on final inflation and the pass-through mechanism. Therefore, lowering rates in March would be premature.
The cash reserve ratio (CRR) decision is easier to take since the market does not see it as monetary easing but as a liquidity supporting measure. The liquidity conditions are quite adverse and a ridiculously large amount is being borrowed from RBI at around Rs 1.7 lakh crore. Clearly the market has been distorted because interest rates should reflect liquidity shortage, which is not happening today. If there was a cap on repo borrowings to the desired extent of one per cent of deposits, there would have been excess borrowing of Rs 1 lakh crore in the call market that would have spooked up rates. This has been eschewed through the use of open market operations (OMO) by RBI to the extent of almost Rs 1.2 lakh crore this year. Therefore, even the text book will say that rates cannot be coming down when the supply of funds is lower than demand since there is little money around.
Earlier, a CRR cut would have been interpreted as being contradictory to the interest rate stance. But today, it is purely a supportive instrument. It will ease partly the liquidity crunch that will be exacerbated by the advance tax payments to be made during the second week of this month. One should recollect that aggressive OMO along with the earlier CRR cut of 50 basis points failed to assuage the liquidity situation, and quite clearly this has to be persevered.
Therefore, in an environment of stringent liquidity that actually should reflect in higher interest rates, and the fear of inflation lurking, a neutral stance on interest rates looks most logical. Rates are still, in effect, low today which would have been warranted by the market conditions. In this scenario it would be better to leave interest rates unchanged until such time as we are confident that inflation is down and liquidity ease to reflect this declining cost of capital.
These views are personal
President & Chief Economist, YES Bank
“It is important to reverse (or at least stall) the process of the current sequential fall in ‘trend growth’, which is inimical to long-run growth prospects”
The Reserve Bank of India’s (RBI’s) guidance in the third quarter review was unambiguous: that monetary tightening has peaked. Drawing comfort from inflation moving along an expected trajectory, the policy focus was seen shifting to support growth. The run-up to the policy also saw average systemic liquidity deficit worsening to Rs 1.2 lakh crore in January. In addition to open market operations (OMO), a cut in the cash reserve ratio (CRR) was deemed necessary since the factors causing this deficit were found to be not just transient (RBI’s intervention in the forex markets), but also structural (rising share of currency in circulation in money supply).
The evolving growth-inflation dynamics warrant a rate cut as early as possible. The output gap is currently negative and the gap has been deteriorating sequentially. Headline GDP growth slipped to a 10-quarter low of 6.1 per cent in Q3 FY12. What is alarming is that the slowdown has been driven largely by a contraction in private sector investment. Growth in capital formation has slipped into a negative zone for two consecutive quarters, clearly a reason to worry since there is limited fiscal headroom going forward to take the onus of reviving growth. On a quarterly rolling basis, the share of investments in GDP has fallen to 28.5 per cent as of Q3 FY12 from a peak of 32.9 per cent in Q4 FY08. Fall in investments will also have a negative impact on inflation in the longer run — ergo, there is a need for balancing the long-term growth-inflation balance.
Persistent elevated inflation has been the biggest bane for India over the past two years. The annual average inflation in FY11 and FY12 has been around nine per cent. In response, the aggressive monetary tightening earned RBI the distinction of being the most vigilant and active central bank in the world. The recent reading of inflation in January indicates an easing of sequential momentum in both headline and core inflation. The average headline inflation in FY13 is expected to ease to 6.5-7.0 per cent, a drop of around 200 basis points over the preceding two years.
A major factor that may disturb this outlook is the recent hardening of global crude oil prices. The modest recovery in the US, China and India’s relatively resilient economies and recent geo-political tensions have buoyed crude oil prices. A fresh infusion to global liquidity through two rounds of long-term refinancing operations is likely to prevent crude oil prices from easing. With a partial pass through, the recent surge in crude oil prices will elevate the extent of suppressed inflation. For RBI, clearly this development poses a significant risk in its anticipated inflation trajectory for FY13.
With this risk on the table, the debate now centres on the timing of monetary policy easing, especially through a rate cut. The liquidity deficit remains worrisome — at more than two per cent of net demand and time liabilities, way above RBI’s indicative level of comfort. A sharp liquidity deficit has inverted the yield curve with short-term nominal rates having hardened in the last two months despite no change in the repo rate and a 50 basis point cut in CRR. In addition, real bank lending rates have risen significantly with headline inflation moderating by 300 basis points since November 2011. As such, the rate cut should be seen as a normalisation of the earlier policy stance rather than the beginning of any easing.
RBI had indicated that a rate cut will need to be preceded by the government’s efforts towards a credible fiscal consolidation not just through a reduction in the fiscal deficit ratio, but also by improving the quality of fiscal adjustment. In an environment of investment-led slowdown and elevated commodity prices, the expectation of a dramatic improvement in fiscal imbalances in just one year may be unrealistic. RBI should draw comfort if the government takes credible action to curtail persistent subsidy overruns.
While oil and suppressed inflation are potent and legitimate risks, these are factors that should impact the extent of rate cuts rather than the beginning of rate cuts — it is important to reverse (or at least stall) the process of the current sequential fall in “trend growth”, which is inimical to long-run growth prospects.