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Markets have behaved as if the Reserve Bank of India (RBI) raised rates, not cut them! Equities collapsed, and rates sold off. While some of this was on account of a further downgrade of the monsoon forecast that was announced shortly after the RBI policy, it largely encapsulates disappointment at the realisation that we are likely at the end of the rate cut cycle.
But I would argue the market reaction is purely a victim of unrealistic expectations. The move to inflation targeting was nothing if not an attempt to make monetary policy transparent. And high marks to the central bank on that front. RBI's inflation targets (six per cent by January 2016 and four per cent by January 2018) have been repeated ad nauseam over the past 18 months, as well as the fact that RBI would like to keep real policy rates in the 1.5-2 per cent range. We believe this is particularly important to both generate the necessary disinflation and, more importantly, re-intermediate household savings from physical to financial assets. So that, when the capex cycle does lift, it is not financed by foreign savings, which could be in shorter supply once the US Fed begins to hike rates. Put these inflation and real interest rates targets together, and the math is not hard: There was never space for more than 50-75 basis points of rate cuts. And, RBI has delivered at the upper end of that range. Yes, growth concerns have risen, but the central bank's primary mandate is to keep inflation contained to creating the macroeconomic conditions that enable sustained growth. The sooner markets realise this constrained optimisation, the less disappointment.
The focus will now turn to other state actors. A weak monsoon is the biggest macroeconomic risk facing India over the next few months. It has the potential to pressure food inflation as well as further depress the rural economy. This is where the government's policy response becomes critical. So far, the government deserves huge credit for keeping food inflation contained. But now the trade-offs will begin to bind. Authorities will need to find ways to both contain food inflation, as well as provide insurance and support to farmers. And some policies (for example minimum support price), while achieving one objective, will severely impede the other. The broader challenge is therefore clear: How to buffer this shock while eschewing fiscal populism. The government did this very successfully in 2014. Hoping for an encore.
Sajjid Z Chinoy
Chief India Economist, JPMorgan
The views expressed are personal
Chief India Economist, JPMorgan
The views expressed are personal
