The Reserve Bank of India (RBI) will unveil its third quarter review of monetary policy on Tuesday. As always, there has been intense speculation on whether the central bank will cut the policy rates and, if it does, by how many percentage points.

More than at any time before any recent policy statement, the circumstances seem right for a rate cut, the first after the 0.50 percentage point reduction in April, 2012. Yet, no policy action of the RBI can be taken for granted. One has to look at some hard data of recent times even before guessing what the RBI will do on Tuesday.

Factors favouring cut

First, the factors which would favour a reduction. After a long period, stretching over three years, the WPI (Wholesale Price Index) shows signs of a sustained moderation. WPI inflation has fallen for three successive months by 0.90 percentage point (on a cumulative basis) to 7.2 per cent in December. The RBI had predicted an increase.

Equally significantly, there has been a sharp fall in core inflation to 4.2 per cent in December from 5.73 per cent in September. Core inflation excludes food and fuel prices, and is an important reference point for monetary policy. Its decline is attributed relatively to stable commodity prices, range-bound exchange rate movements and weaker domestic demand. The big question is whether all these moderating factors would continue.

Optimists believe that if the trend in WPI inflation continues, the year-end (March, 2013) figure will be even lower than the RBI projection of 7.5 per cent. Since the RBI has already shifted the focus to growth from inflation, a 0.25 percentage point cut in the repo rate is possible and, according to many, the absolute minimum necessary to kick-start the faltering investment to revive the economy.

GDP growth is unlikely to be very much above 5.5 per cent in 2012-13, and industrial production (Index of Industrial Production numbers) has grown at an average of only 1.1 per cent over 12 months. After a long lapse, the government has started emphasising fiscal consolidation. The accent on expenditure control through a reduction in subsidies is considered favourable to a monetary easing. On the revenue side, it is recognised that revenue buoyancy is clearly dependent on GDP growth.

Any tinkering with tax rates may be counter-productive. It is admitted that the steps towards fiscal consolidation will make a larger impact next year (2013-14) than during the current year. Even so, their capacity to create a favourable climate for monetary easing cannot be downplayed. After a long time, the RBI’s expectation from the government seems materialising.

There is, of course, the opposite view. An important point in favour of maintaining the status quo on interest rates is that inflation, though falling, is still well above the RBI comfort zone of 5 per cent. Even if circumstances favourable to a moderation continue (such as benign commodity prices), the WPI inflation is unlikely to reach that level by the year end.

RBI Governor D. Subbarao’s statement that there is limited scope for monetary stimulus since the level of inflation is still very high is considered significant as it recognises the sharply different interpretations of available inflation data between its level and declines recently.

Then there is the consumer price index (CPI) inflation, which spiked sharply to 10.56 per cent in December from 9.9 per cent in November. The sharp divergence between WPI and CPI indices is largely due to food (has a greater weight in the CPI) and house prices (WPI does not capture these). The RBI cannot obviously ignore the CPI — it plays an important part in conditioning inflation expectations. The question is: by how much will it restrict RBI’s scope to ease monetary policy?

Divergent policy moves

There are two other important points that would indicate the divergent policy moves. The first, which tilts the balance in favour of a rate cut, is from a reading of the most recent policy statements.

The mid-December policy statement explicitly hinted at a rate cut in the fourth quarter (January-March 2012-13). Pointing out that inflation was steadily moderating, it said that from then on “monetary policy has to increasingly shift focus and respond to threats from growth.” It may be that the RBI has not committed to a rate cut but that is how the last policy statement has been widely interpreted.

The second point that would indicate an entirely different policy move arises from the easily forgotten maxim that monetary policy is for savers too, not just borrowers. It is a fact that all savings instruments are giving low, if not, negative returns (those who are shifting to physical assets such as gold).

Deposit growth with banks is slowing. It is unlikely that the target of a 15 per cent growth in deposits will be achieved. A rate cut now will be regressive as far as the vulnerable savings-class is concerned. But then they do not have a chamber or apex body to argue their case.

On balance, therefore, it looks like a small rate cut by 25 basis points on Tuesday. It may be accompanied by a similar reduction in the Cash Reserve Ratio.

narasimhan.crl@thehindu.co.in