The dollar rose on no news’. This was the concluding sentence of a mock overnight forex market report penned by economist Jacob Frankel about three decades back. The Indian financial markets rose handsomely on the very positive news of a ‘surprise’ 50 basis points cut in the policy rate by the Reserve Bank of India (RBI) on Tuesday. Among others, the price of 10-year government security moved higher, with its yield falling by about 17 basis points over the following 48 hours.
In financial markets, as in life, surprises are rare, by definition. Major central banks, with the exception of the People’s Bank of China, perhaps, tweak their policy rates by 25 basis points at one go on most occasions.
A 50-basis point rate cut can happen under either of the following circumstances:
One, when a central bank comes to the conclusion that it should have cut the policy rate more in the past, particularly in the last review. And, therefore, it seeks to make amends for the missed opportunity. By doing so, the central bank wants to be sure that it is not left ‘behind the curve’ — to use jargon. Two, when fresh data coming out since the last review clearly demonstrate that the economy is on a steep downward trajectory, particularly in terms of output, inflation and employment. Clearly, a decision to cut the policy rate by 50 basis points must be backed by a whole host of relevant data and serious analysis. To be sure, a surprise cut in rate cannot be driven by common sense alone.
What conclusions are one led to when the above framework is applied to evaluate the RBI’s latest action? RBI expects CPI inflation to be a shade better than the target of 6 per cent by the end of the current fiscal and would strive to bring it further down to 5 per cent in fiscal 2017-18. Inflation expectations, both for the short- and long-term continue to be high. Growth projection for the current fiscal at 7.4 per cent, though slightly less than 7.6 per cent projected earlier, is still impressive reflecting the recovery underway.
The monetary policy report clearly states, “Services inflation has been more persistent relative to goods inflation”. The cost of education and healthcare have been growing at double digit rates hurting the middle class as well as the pensioners, and it is here the inflation expectations get hardcore. The government’s fiscal position is unlikely to improve for the better in the near future, what with more payouts on account of OROP (One Rank One Pension) and the 7th pay commission’s recommendations.
One wonders, how a strong accommodative signal is conducive to achieving disinflation, particularly when inflation expectations remain high and more or less unchanged since the last review in April, 2015? Real interest rate, if calculated on the basis of expected inflation as revealed in surveys (and not what RBI expects) will be much below 1.5-2 per cent range (actually negative), as envisaged by RBI.
Since the last review, one has come across strong opinions on the need to lower rates with India Inc. projecting as if the interest rate is the only determinant of their investment decision and the government’s chief economic adviser highlighting that India may be headed towards deflation based on WPI readings, implying high interest rates are throttling growth. Governor Rajan, who took the reins of RBI in 2013 at a time when the rupee was in a free fall, had won the confidence of international investors that RBI will be committed to rules driven policy making with utmost transparency. The average CPI inflation between 2006 and 2013 was 9 per cent and although several other factors contributed to lowering of inflation subsequently, Dr. Rajan’s role in establishing the credibility based on sound inflation targeting monetary framework was the cornerstone for the new course charted for India’s macroeconomic policy.
In 2015, Dr. Rajan runs the risk of losing this hard-earned credibility by yielding to market appeals for lowering rates. It will take a long-term credible commitment from RBI to low and stable inflation rather than sharp shifts in policy to spur growth. Central bankers in advanced economies have been trying to use monetary policy to substitute for the lack of implementation of hard structural reforms and painful adjustments by their governments. It will not work. Hopefully, Dr. Rajan does not emulate his peers in advanced economies and sticks to the core mandate of price stability and independence of monetary policy decisions. One often hears that the long-term vision of Dr. Rajan is to set the stage for sustainable high growth for India with structurally lower inflation, and with less dependence on subsidy and largesse and discretionary intervention in the financial sector. This vision must remain intact and be pursued consistently.
Mr. Himadri Bhattacharaya is Senior Advisor, Riskontroller Global, U.S. and Mr. Sivaprakasam Sivakumar, is Managing Director, Argonaut Global Capital LLC, U.S.
