If Subbarao cuts rates, it will be done only grudgingly

If the Reserve Bank’s macroeconomic and monetary review released today is any indication, one may expect a token cut in interest rates due to a slowing economy, but the bank appears totally unconvinced about the trajectory of inflation.

Tomorrow, 29 January, the bank will announce its Third Quarter Policy Review and the widespread expectation is that it will cut repo rates by 25 basis points (around 0.25 percent). A bonus would be a cut in the cash reserve ratio in view of liquidity pressures.

The macroeconomic review makes it clear that GDP growth in 2012-13 may fall even below 5.8 percent before rising next year, but the moderation in inflation is expected to be very small. In fact, despite noting the fall in inflation below the baseline projection of 7.5 percent, the RBI notes that “suppressed inflation continues to pose a significant risk to inflation in 2013-14. As some of the risks materialise, the inflation path may turn sticky.”

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Clearly, the Reserve Bank appears totally unsure about the efficacy of the government’s actions, despite the enthusiasm shown by the pink press and the stock markets about “reforms”. Says the review rather curtly: “The growth slowdown in India continues with growth remaining below potential for the fifth successive quarter. Policy initiatives of the government are yet to show up fully or definitively in data. Revival may take some more time.”

[caption id=“attachment_604976” align=“alignleft” width=“380”] Reading between the lines, it seems the RBI is unhappy about the fact that it may still have to cut rates due to the slowdown and pressure from North Block. AFP[/caption]

The Reserve Bank also tut-tuts a bit on the kind of fiscal adjustment being attempted. It says: “The quality of fiscal adjustment remains a concern, even as fiscal risks have reduced in 2012-13. Government is working towards achieving a revised fiscal deficit target of 5.3 percent of GDP by restricting both plan and non-plan expenditure during the last quarter of the year, even as significant shortfall in tax revenue is likely.”

The RBI does not seem to think this cutting of plan expenditure is right. So it says: “Increased public investment to crowd in private investment along with removal of structural impediments that are slowing private investment are needed to pull the economy out of the current slowdown.”

The RBI underlying advice is: cut waste and subsidies, not investment.

The big worry for RBI Governor D Subbarao clearly is the external front - and if he holds back on reducing interest rates tomorrow, it will be because of this. “The widening current account deficit (CAD) has emerged as a major constraint in easing monetary policy. With the likelihood that CAD-GDP ratio may exceed 4 percent of GDP for the second successive year in 2012-13, prudence is necessary while stimulating aggregate demand.”

That is, government should not think that cutting rates is a panacea, or that spending its way out of a slowdown is an option.

The RBI also made it a point to indicate that it is carrying the can for government’s CAD problems. It is forced to do something that is not prudent. “Strong capital flows have facilitated financing of CAD, resulting only in marginal drawdown of reserves. While increased FII debt investment limits may enhance inflows, they do not provide a solution to CAD financing on a sustainable basis.”

The RBI’s biggest red flags continue to be centred around inflation. Even while admitting that core inflation (non-food, non-fuel) inflation was down and unlikely to rise anytime soon, it continues to fret about wage inflation pushing up prices again. “Rural wage inflation declined marginally but remained high at 18 percent. In organised manufacturing, increases in staff costs remained in double digits. "

But the central bank is totally unconvinced about inflation being in control. It says: “Going forward, risks remain from suppressed inflation, pressure on food prices and high inflation expectations getting entrenched into the wage-price spiral. The inflation path for 2013-14 could face downward rigidity.”

That’s Subbarao-speak for saying inflation ain’t coming down anytime soon. The official expectation is that Wholesale Price Index inflation will moderate from just 7.5 percent now to about 7 percent in 2013-14. Hardly, a great triumph for monetary or fiscal policy.

Reading between the lines, it seems the RBI is unhappy about the fact that it may still have to cut rates due to the slowdown and pressure from North Block. We will know if it still goes ahead and does it just to oblige P Chidambaram.