Central bankers as a breed are not exactly known for their gambling instincts, driven as they are by cold economic numbers in their decision-making. Yet, Reserve Bank of India Governor D. Subbarao has gambled big in deciding to drop policy rates by a larger-than-expected 0.50 percentage points in his Annual Monetary Policy Statement announced Tuesday. The move is also in line with the hoary tradition of central banks surprising markets — it was a pleasant one this time round as the money was on a token cut of 0.25 percentage points. There was no surprise, however, in the decision to keep the cash reserve ratio unchanged which, given the comfortable liquidity position, was expected. The RBI says it was driven by two major considerations in its decision to cut rates for the first time in three years: the significant deceleration in GDP growth in the last fiscal and the softening of inflation to levels that the central bank is comfortable living with. The fall in GDP growth to below the trend rate seen in the post-2008 crisis period seems to have spooked the RBI badly as there is more than one reference to this in the policy statement. The rate cut should, of course, please the government which was batting for it in rather brazen fashion as seen from Finance Minister Pranab Mukherjee's statements last week.

While the deed is done, the RBI may yet cut a sorry figure if things don't pan out as envisaged. Inflation is “sticky” and above the tolerance level of the central bank. Even if it is assumed that 6.5 per cent inflation, which is the RBI's projection for March 2013, is the new level of tolerance, there are enough factors to push it above this mark. Higher global oil prices have not been passed on to consumers yet and it is possible the government was waiting for the RBI policy to get out of the way before doing so. This will have a cascading effect on prices across the economy, pushing up inflation. Second, if the monsoon fails, there would be a rise in prices of food commodities. The RBI has acknowledged these risks, as also the possibility of the government failing to meet its deficit target, thus adding to inflation. There is also the issue of financing the current account deficit which can be aggravated by a further rise in oil prices or by a drop in foreign capital inflows into the stock market. The hope appears to be that a big bang reduction will stimulate investment and sentiment, leading to growth, which in turn will help rein in all the spectres haunting the economy. The RBI's projection of a rather ambitious 7.3 per cent growth this fiscal underlines the reasoning behind its bold gamble. The question is, will it pay off?

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