Why Modi and Jaitley should forget about any interest rate cuts this year

In the monetary policy announced on 5 August, Reserve Bank of India (RBI) Governor Raghuram Rajan reiterated his commitment to focus on bringing down inflation.

This is as it should be, but expectations that he may start bringing down rates as soon as inflation look like easing remain strong. These may be misplaced and amount to a misreading of his intent.

In his post-policy interviews Rajan clearly indicated that his fight against inflation is not a short-term thing. In his Business Standard interview, he said: “The problem in the past few fights against inflation has been that every time we look like we are succeeding, the clamour arises that we have had high interest rates and inflation is coming down, so why don’t you cut interest rates. But we don’t want to keep fighting inflation every two years, which is what we have been doing over the past five-six years.” (Italics mine).

Rajan is not talking about this year’s inflation trends, but inflation over the next few years.

What this means is that expectations of early rate cuts are overblown, since Rajan wants to kill high inflation for good. His target is 6 percent consumer inflation by January 2016 - which means he will watch for a sustained fall most of this year and the first half of next year before accepting that inflation is truly down and not merely seasonal or the result of a base effect (ie, lower current inflation because of a higher base in the previous year).

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In fact, the Modi government and businessmen should stop fretting about interest rates and instead focus on what they need to do to get investment restarted. For the government, it should be about fixing the fiscal deficit and taking supply side measures to reduce food inflation; for business it means taking a longer term view of business. If Rajan delivers, one can expect higher growth over longer stretches of time from 2016.

Apart from his interviews, Rajan’s policy actions and the ground situation also indicate that interest rates will stay high for longer than everybody has come to expect.

In his policy, Rajan, for example, reduced the statutory liquidity ratio (SLR) for banks to 22 percent, and also made changes to rules on bonds kept in the held-to-maturity category - where they are insulated from price swings. Under the new rules, banks will have to mark more of their bonds to market - and take losses on their bond portfolios.

The bond markets reacted to this by pushing up yield rates, with the 10-year government bond yield rising to 8.64 percent on 8 August from 8.44 percent about 10 days ago. This is an indicator that despite falling inflation, government borrowing costs may not fall.

But there is another pressure point coming on rates. According to another Business Standard report, the RBI may cut SLR rates to 20 percent sooner than later in order to support its new liquidity coverage norms. From 1 January 2015, the RBI wants banks to maintain at least 60 percent of their monthly cash outflows in highly liquid securities. This means banks need stronger management of their treasury investments - something a faster shift to 20 percent SLR will accelerate.

A third reason why the RBI will be loath to lower rates quickly is the rupee. If global market trends prompt a reversal of capital inflows, the rupee will be volatile. On Friday (8 August), the rupee briefly plunged to a five-month low of Rs 61.74 against the dollar as oil prices rose on Iraq tensions.

The RBI probably wants to keep the rupee around 60 to the dollar, but if global risk-aversion grows, it will be hard put to maintain the rupee’s value without keeping interest rates where they are - or even temporarily raising them.

The last reason why rate nirvana is not round the corner is banks’ own bad loans. As the Bhushan Steel case shows, bad loans remain a major concern, and this will temper their enthusiasm to cut loan rates. The RBI can cut repo rates, but banks will be unwilling to pass on the cuts when they nurse large NPAs. They need the cushion of higher rates to manage their margins and cover their losses.

The message for Narendra Modi and Arun Jaitley is simple: don’t count on significant rate cuts for at least another year. In fact, they should forget about it altogether for the foreseeable future. Luckily for Jaitley, his recent blog on the monetary policy does not suggest that he is overly optimistic on rate cuts. Good for him.