Will Raghuram End The Self-Imposed Exile on Hiking Interest Rates?
The chorus for a rate cut is unlikely to prompt Reserve Bank of India (RBI) Governor to take any action at the bi-monthly review of its monetary policy on December 2. "The pressure from all quarters is huge but Rajan is unlikely to respond," a senior financial-sector player said. Markets have the habit of front-loading rate cuts, and it is no exception this time. Since October 13, when the retail inflation data for September were release, yields on the 10-year benchmark bond have softened by 23 basis points to a 14-month low.
The expectation of a rate cut has also gained momentum due to softening of crude oil prices, which has fallen 14 per cent since the previous policy review on September 30. Economists say a 25-basis-point cut in interest rate at this juncture, which has already been factored in, will not boost investments all of a sudden, given the structural bottlenecks. And Rajan, who has a penchant for surprising the market, might rather go for deep rate cuts when he has inflation firmly under his control. But market players say a closer look at the numbers shows why Rajan would refuse to budge on the rate front this time. The rate of Consumer Price Index (CPI)-based inflation has fallen 330 bps since last September. Of this decline, 185 bps has been due to softening of food prices and another 100 bps on account of falling oil prices. So, of the 330-bp fall, 285 bps is accounted for by commodity prices, which could move either way in the coming months. The decline in inflation has not been due to a demand compression.
In September, the rate of CPI-based inflation was 6.46 per cent, the lowest since a new series was launched in January 2102 - this was on the back of softening food prices. Food inflation declined on a month-on-month basis due to base affect, and as uncertainties over a weak monsoon ebbed. Food prices might not see a decline in the coming months, as the prices of some vegetables like potatoes have inched up in October. The favorable base might also reverse in the coming months, making the headline numbers sticky.
Pessimistic Cues from Global Oil Prices
The next factor is the global crude oil prices. A rate cut in December, if that happens, will implicitly assume commodity prices to remain soft throughout 2015. If energy prices move in the other direction, domestic inflation - where the prices of both petrol and diesel are deregulated - will quickly reverse. In a regulated environment, it is the fiscal deficit that absorbs the shock of an energy price increase. But when prices are set free, it is inflation where the impact is felt.
So, the majority opinion is that Rajan will think twice before hurrying a rate cut. His predecessor was often criticized for cutting the interest rate prematurely, since inflation came back with a vengeance on at least two occasions.
The December policy will also be a few months before a new monetary policy framework kicks in. Under this, a monetary policy committee will be set up and be accountable for its action, making the decision-making process transparent. Rajan might like to wait for this framework to be put in place before reversing his policy stance, experts say.
The new framework, suggested by a committee headed by RBI deputy governor Urjit Patel, had depicted a glide path for inflation. The inflation target was set at eight per cent for January 2015 and six per cent for January 2016. It also set four per cent as target for CPI-based inflation (+/- 200 bps). So, even if inflation is at 6.5 per cent, the final objective is to bring it down to four per cent.
Economists say it will indeed be a bold call for Rajan if he still decides to cut rate in the December policy review. "But central bank governors often choose to be prudent rather than bold," a senior economist says.
RAJAN'S FIVE REASONS
- COMMODITIES: Fall in CPI-based inflation is due to softening of commodity prices, and not because of demand compression
- OIL: Global crude oil price might not fall further; it could rather harden in the second half of 2015, reversing the inflation trajectory
- FOOD: The decline in food prices in September might not be repeated in the coming months
- LOW BASE: The benefit of a low base may not be there from Dec
- THE US FACTOR: US Fed's action on rate is still awaited.