Cry for rate cut gets shriller but RBI's Rajan may ignore the clamour

The cry for interest rate cuts is getting shriller.

Armed with the falling commodity prices, the decelerating inflation and a slowing economy the lobby for rate cuts seems to be working overtime to put pressure on RBI governor Raghuram Rajan.

Surprisingly, the government also has joined the chorus, with finance minister Arun Jaitley himself making a case recently.

“Currently, interest rates are a disincentive. Now that inflation seems to be stabilizing somewhat, the time seems to have come to moderate the interest rates,” Jailtey told The Times of India in an interview.

Jaitley’s comment seems to have given interest rate lobbyists more fire power.

“Since Indian aggregate demand remains weak, and output is much below potential, if the glide path for inflation looks achievable, rates should be cut,” Ashima Goyal, professor of economics at Indira Gandhi Institute of Developmental Research and a member of the RBI’s Technical Advisory Committee (TAC), has been quoted as saying in a report in The Economic Times today. TAC is a committee that advises the RBI on monetary policy.

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What has given ammunition to the lobbyists for interest rate cuts is the decline in inflation. According to the latest government data, retail inflation eased to a 33-month low of 6.46 percent in September. Moreover, the fall in inflation is likely to continue for some more time as international oil prices are on the decline and the government-run oil companies have also cut fuel prices in tandem.

To top it all, the data released last Friday showed that the country’s infrastructure sector growth slowed to 1.9 percent in September. This compares with a 5.8 percent year-on-year increase in August. The index covers eight sectors, coal, crude, natural gas, petroleum, fertilizers, steel, cement and electricity and also has 38 percent weight in the IIP.

Prima facie, one could see the current set of numbers as a supportive factor that strengthens the argument that the Reserve Bank of India (RBI) should go for a rate cut sooner than it originally plans to do.

But the truth is chances that lower inflation and industrial activity triggering an early rate cut are highly unlikely on account of a few factors.

Firstly, even though prices of food and vegetable items have eased in the recent past, the high base of retail inflation in the corresponding period of last year was a prominent factor for the larger-than-expected decline in the latest set of CPI numbers.

In September last year, the CPI inflation stood at 9.84 percent. Base effect means, if the base is high in the year-ago period, even a similar absolute increase in the inflation numbers this time will show a lower rise.

What this means is it will take two more months till November before the base effect on CPI inflation begins to fade away, which means that retail inflation numbers might register a fall until November even though there is an absolute rise.

“Base effect will keep (retail) inflation down for 3-4 months after which it will rise,” said D K Joshi, chief economist at Crisil rating agency, said.

“Average inflation for the year should be within 8 percent. I do not expect any rate cut this fiscal year,” Joshi said.

Second, it is too early to conclude that the threat of high prices of food and vegetable items have begun receding. Given the 12 percent deficiency in monsoon, the RBI will probably wait for a few more quarters to see its impact on the pattern in the prices of vegetables.

The observations made by Rajan at the 30 September monetary policy review on food inflation are highly critical.

i) “The full impact of the skewed rainfall distribution carries risks to the future path of food inflation.”

ii) “Future food prices and the timing and magnitude of held back administered price revisions impart some uncertainty to an otherwise improving inflation outlook, where lower oil prices, a relatively stable currency, and a negative output gap continue to put downward pressure”.

iii) “Base effects will also temper inflation in the next few months only to reverse towards the end of the year. The Reserve Bank will look through base effects.”

Third, even though the RBI has a stated target to bring down retail inflation (to 8 percent by this January and 6 percent by a year later), there is strong chance for a change in this roadmap when the expected change in inflation management sets in.

The government and RBI are currently discussing a change in the way monetary policy has so far worked in India. The new framework will possibly see the government setting the inflation target and the RBI working towards achieving the same.

One cannot rule out the chances that the new framework, which may come to effect from April next year, would offer a different inflation target to the RBI, which would influence the timing and magnitude of the rate cut.

For now, Rajan, who has made it clear his intent of fighting the “anti-inflation fight once and for all”, is unlikely to get carried away by the lower inflation number and change his course of action on possible rate reversal.