The mid-quarter monetary policy review unveiled by the Reserve Bank of India (RBI) on June 18 grabbed headlines not so much for what it did but for what it did not. Large expectations of an interest rate cut, along with other forms of monetary easing such as a CRR (cash reserve ratio) reduction, were built up during the run-up to the policy announcement. So much so, the question was not whether, but by how much, the RBI would lower the repo rate and/or the CRR.
In the event, the decision of the central bank to leave the policy rates and the CRR unchanged was the big news. It is not as though those who assumed that an interest rate cut was on did not have a case. Such clamour is seen on the eve of every credit policy review. But giving considerable weight to the argument this time has been a slew of weak macro-economic numbers pointing to a slowdown.
Contributory factors
Economic growth slowed down over successive quarters of last year to touch a low of 5.3 per cent during the January-March 2012 quarter. For the whole year, it was 6.5 per cent, a nine-year low. Deceleration in industrial production, from the supply side, and weak investment demand, from the demand side, have, in particular, contributed to the slowdown. The index of industrial production (IIP) increased by just 0.1 per cent in April. In times like this, a monetary stimulus through a rate cut is recommended.
There was another reason why a rate cut was considered imminent. In its annual credit policy statement of April 17, the RBI announced a larger-than-expected 50 basis points cut in the policy rates. Since the RBI had, for quite sometime before, been hinting at an end of a rate tightening circle, the annual policy statement was taken to be the starting point of an easier interest rate policy which will be continued in the next credit policy review. However, two months later, when the RBI held on to the rates, it was not thought of as a pause, which it is, but a reversal of recent monetary easing.
Maintaining status quo
Whether it has merely paused or abruptly ended its relaxed interest rate stance is not particularly relevant. The RBI has made it amply clear that monetary policy action, at any given point, will be determined by its reading of the macro-economic situation, especially inflation and growth.
The decision to maintain status quo has been guided by the fact that inflation remains a potent force. WPI inflation for May has been at around 7.55 per cent (7.23 per cent in April) on the back of high food prices.
Consumer price inflation remains in double digits. The only saving grace - the moderation in core inflation (inflation, excluding the volatile food and fuel items) has remained at below 5 per cent - is not a good enough reason to effect interest rate cuts. Upside risks to inflation continue to remain strong.
The RBI has also put forth the argument that interest rates have a limited role in reviving growth at this juncture. Factors other than interest rates have contributed to the slowdown. A turnaround in growth driven only by lower interest rates is unlikely given the poor investment climate. Lower interest rates can help stimulate consumption demand through its positive impact on retail credit but cannot lead to a sustained investment activity unless complemented by steps aimed at policy-related bottlenecks.
A rate cut is not the right medicine for curing the ills of the economy also because it would have added to inflation risks. The weaker rupee might cause higher imported inflation risks. Should the government eventually raise diesel and kerosene prices to contain the subsidy bill, inflation and inflation expectations will go up. The hike in excise duty and service tax will be a contributory factor.
The RBI, almost certainly, has to reckon with India’s twin deficits — fiscal and current account — before deciding on interest rates. Urgently needed steps aimed at fiscal consolidation, which the union budget promised, have not materialised.
Sentiment
It may be arguable, but an interest rate cut would probably have had the psychologically important consequence of preserving, if not boosting sentiment such as what is seen in the stock markets. The counter argument is, for that to happen the rate reduction ought to have been of a higher magnitude, say at least 0.50 percentage points. Besides, it is extremely doubtful whether sentiment can be sustained over the long-term through rate cuts and other short-period monetary measures.
