As the Reserve Bank of India (RBI)'s monetary policy announcement due on the 29th of this month approaches, the demand from industry, a section of the economist community and the finance ministry for a cut in the RBI's policy or repo rate appears to be growing more strident. Some heavyweight economists and (somewhat predictably) industry are clear that they will not be satisfied with a meagre quarter of a percentage point. They prescribe a deeper cut over the near term - perhaps as much as a full percentage point. As a sideshow there is also a Delhi versus Mumbai divide at play. A number of the financial sector economists believe that a cut on the 29th should be the last or the penultimate cut while the Delhi-based policy-wallahs seem fairly united that much larger reductions in the interest are possible.
My sense is that while a small cut on the 29th looks likely, the RBI will disappoint the 'big cut' lobby going forward. For one thing, the RBI appears to believe that there is merit in remaining focused on the Consumer Price Index (CPI) and not paying much heed to the persistent 'deflation' in the Wholesale Price Index (WPI). Some would see this is as a fair point. The central bank now has a specific mandate to deliver on the CPI and the CPI alone. Why should it suddenly start to get swayed by what is happening to something that lies outside its remit? Those who argue that the deflation in the WPI should logically spill over to the CPI and thus pave the way for a sharp fall in the latter might be disappointed to know that there is no causal link between the 'core' (stripped of the fuel and food elements) components of the two indices.
The second point the RBI seems to make is that there is a statistical 'base effect' at play. While the prints seem comfortably low now the sheer heft of a declining denominator will pull the inflation rate up going forward. Thus over the next few months we will see rising CPI inflation with the fiscal year end numbers edging close to the upper bound of its target band of two to six per cent.
The third source of anxiety for the central bank could stem from the poor performance of the monsoon in the second half of the season. This could impact on food prices as the harvest begins in full swing in October. The bigger risk is that low reservoir levels, poor moisture content and so on could affect the winter crop cycle right from the stage of sowing. One really can't blame the central bank for this. It would take a singularly optimistic central bank governor to be staring at a 13 per cent shortfall from the long term average rainfall and not worry about food inflation.
It is possible to argue that better supply management, both through domestic market intervention and imports. Global prices of 'soft' commodities are spectacularly low and that should bring comfort. The counter to this is that even if it sees past temporary food price shocks and relies on the supply side to even this out, there are key components of CPI-based inflation that are way too sticky for comfort. Look at inflation for August when the headline number showed inflation of 3.7 per cent, inflation in key components like household goods and services printed at 5.36 per cent, health at 5.38 per cent, and education at 6.1 per cent.
The fourth on the list of worries is the possibility of a reversal in the path of fiscal consolidation especially from the next financial year. I am not passing judgement on the rationale for revising government salaries or unifying pensions across ranks for our defence veterans but the hard fact is that these could shore up the government's bill quite considerably going into the next financial year. These expenditures would really be in the nature of enhanced income transfers and consumer demand could suddenly ratchet up. On the revenue front, the sizeable divestment programme could see a gaping hole this year and the next. With emerging markets in the doldrums and money 'rotating' back to safe havens like the US, the task of raising money from the global and domestic markets is likely to be daunting.
If I were forced to pick the one reason why the RBI will be reticent about slashing rates drastically is its concern about financial savings. Of the various factors that influence our central bank's policy stance, the impact of a dwindling real interest rate on things like bank deposits and the risk of households switching to physical assets like gold and real estate is, in my assessment, on top of the list. Again, let's not blame the RBI for fretting about this. We did have a serious crisis on the financial savings front just a couple of years ago that fed other imbalances like the current account. In 2010-11, the financial savings rate of households was 10 per cent of GDP. By 2013-14 it had dropped to seven per cent.
Finally, there is this this business about the global macroeconomic situation. If capital outflows come under pressure again, as is likely, and the rupee begins to depreciate, isn't there a case for holding the rate a defensive move?
I do not hold a brief for the RBI. I think there is a fundamental problem with this entire paradigm of CPI targeting. It forces the central bank to fight a range of embedded 'structural' price pressures through the blunt instrument of the interest rate. It does not pay adequate attention to the truly cyclical components and drivers of inflation. But I will save that for another column. The limited point that I make here is that given the paradigm it is operating in, it might have a strong case in limiting its rate cuts to a quarter of a percentage point or half at best for the rest of the financial year.
The writer is chief economist, HDFC Bank. The views are his own.
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