Raghuram Rajan's inflation dilemma: Why India may have to wait longer for a rate cut

Raghuram Rajan has a penchant for surprises.

On his first day as governor at the Reserve Bank of India (RBI), the former chief economist at the International Monetary Fund, unveiled a fresh roadmap to overhaul the conventions of India’s financial sector. It surprised everyone, who was expecting a customary 10 minutes address from the new face of the central bank. That was a break from the traditions.

But, Rajan loves to spring surprises. Every time financial markets expected a rate action from him in one direction, his final verdict came the other way. That was so, beginning with his first monetary policy announcement on 21 September.

Rajan increased the key policy rate, repo rate, by a quarter percentage point when the markets had expected a status-quo in the face of slowing growth. He spoke with conviction on his policy priorities.

That was just the beginning. Rajan is his own man. He has repeatedly ignored the clamour from top politicians and powerful industrialists for a rate-cut to aid an anemic growth, citing that inflation is a bigger enemy. Slowly everyone got attuned to his ways.

Of the six times Rajan presided over the monetary policies, Rajan increased the key policy rate thrice by a total of 75 basis points (bps) to 8 percent and opted for status-quo thrice.

One bps is one hundredth of a percentage point.

When the Reserve Bank is set to announce its next monetary policy review on 5 August, will Rajan break from his self-practiced tradition and go for the first ever rate cut in his life as the RBI governor? Many think time is right (some believe it is high time) for a rate cut to prop up the sub-5 percent economic growth seen in the recent quarters.

Inflation targeting?

But chances are low that Rajan would do that for two reasons:

One, there is a tactical shift in the policy stance of the Indian central bank, especially after Rajan took over the reins with regard to inflation targeting. Rajan has accepted inflation control as the primary target of the RBI, even if he wouldn’t acknowledge it officially for some reason.

Inflation targeting, in economic parlance, refers to a stated policy of the central bank in which the apex bank make public a specific target for inflation and attempts to achieve that target through the use of available monetary policy tools.

The RBI, during the regime of Duvvuri Subbarao, has all along maintained that the RBI cannot be an inflation targeting central bank unlike those of countries like New Zealand and Chile. Rajan too has maintained the same stance and has refused to admit that he has embraced an inflation target, but in reality, the central bank has quietly moved to inflation targeting already.

That’s where the problem lies. The retail inflation has stayed between 9 percent and 10 percent for consecutive nine months until December and above 8 percent in the subsequent months until May. Only in June, the CPI fell below 8 percent-the central target for the RBI for January 2015-but that fall is attributable to higher base effect, rather than a genuine fall in the prices.

Trends in the wholesale price index (WPI)-based inflation(WPI fell in June to 5.43 percent) are somewhat irrelevant at this point, because the central bank has officially accepted the central forecast of Urjit Patel panel that projected consumer price index (CPI) inflation down to 8 percent by January, 2015 and 6 percent by January, 2016.

On the other hand, the WPI core inflation, or non-food, non-oil manufacturing inflation, has remained high in the recent months. That too makes a case against a rate cut. The RBI typically attaches a lot of importance to core inflation because of its less volatile in nature, which makes it a better price indicator.

Core inflation has stayed above 3 percent for the last eight quarters. Although it eased a bit post March, the numbers have been sticky in the last three months.

Raining problems

Second, the biggest worry for Rajan as he sits down to frame the policy document will be the not-so-good monsoon statistics. The monsoon, which arrived behind schedule, is forecast to bring below-average rainfall, in turn, raising concerns of a draught-like situation after five years.

A poor monsoon can upset the farm production and can have major implications on the price levels in the ensuing months, especially with regard to that of fruits and vegetables. The June CPI data shows that vegetable prices went up by 8.73 percent in June 2014, compared with the year-ago period.

In the June policy review, Rajan had given an assurance that he is “committed to keeping the economy on a disinflationary course”. Considering the higher base effect and expected monsoons ills, it might be too early to judge that inflation has subsidised in a sustainable manner.

Perhaps, the central bank would wait for another quarter or so before even thinking about a rate cut.

On 5 August, in all likelihood, Rajan will stick to a status-quo in rates even at the cost of sacrificing growth, unless, of course, the man has more surprises in store.