Lady luck smiles on Rajan, but it's still about fundamentals

Lady luck has smiled at the ‘handsome’ Raghuram Rajan on the eve of his first monetary policy statement as RBI Governor. So what does it matter, if she happens to be in the guise of the bearded chairman of the US Federal Reserve, Ben Bernanke.

America’s central bank surprised markets on September 18 by choosing to retain its huge monetary stimulus in the world’s largest economy contrary to its earlier hint in May that it would in fact begin to withdraw it soon.

The very thought of continued cheap liquidity sent the Sensex soaring above 20,000 as the rupee climbed towards 60 to the dollar.

[caption id=“attachment_1119515” align=“alignleft” width=“380”]  when Ben Bernanke or his successor eventually decide to roll back the stimulus, Rajan and the Indian economy will not need lady luck to lend a helping hand. Reuters[/caption]

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The economic crisis which looked imminent one month ago seems to have vanished into thin air. Rajan said he had no magic wand when he took office, but things have worked magically for him, when compared to the tortuous plight of his hapless predecessor Duvvuri Subbarao.

Unfortunately lady luck has a habit of being fickle. Rajan must not be distracted. It’s still about the fundamentals, stupid. There is something awry in an economy when the Sensex hits the same 20,000 level whether growth is 5 percent (as it is now) or when it is 9 percent (as it was some years ago). The fact is that the Indian economy is now on steroids administered by the US Fed. It is not sustainable therapy, but what it does do is give room for policymakers in Delhi and Mumbai to set their house in order; start pushing the fundamentals to where they ought to be.

Raghuram Rajan still has a tough call to make tomorrow. Inflation, as measured by the wholesale price index is at a six month high of 6.1 percent. Consumer price inflation has never really come down below double digits. Growth is sclerotic at sub-5 percent levels. Stagflation is a nightmare scenario for a central banker. When he took over as RBI governor, Rajan was unambiguous that inflation would be his priority. But he retained the right to surprise markets.

Ideally, with luck on his side, he should gamble on a cut in interest rates so desperately necessary to stimulate growth. There is considerable evidence that private demand has collapsed and that persistent inflation has more to do with supply constraints than excessive demand.

Courtesy the Fed, Rajan need not worry about the currency. Of course, in an ideal world he should not be managing the rupee at all but in an election year his political bosses would have forced him to be mindful of the rupee’s rate of exchange.

Rajan has the option of a different kind of surprise: a hike in interest rates. But that would be overkill, especially in a scenario where the currency does not need artificial support. It would certainly deaden any hint of recovery in growth even if it signals his determination to contain inflation.

The third option is to do nothing. In the world of central banking, even that is a major decision, as Bernanke showed yesterday. Rajan may opt for that as he waits for the government to send clearer signals about its intent to lower the fiscal deficit. Ultimately, a credible fiscal contraction accompanied by monetary stimulus is the only combination that can revive the Indian economy. That is really what will set the fundamentals (growth, inflation) right. So when Ben Bernanke or his successor eventually decide to roll back the stimulus, Rajan and the Indian economy will not need lady luck to lend a helping hand.