Why RBI's Subbarao will find it tough to cut interest rates

It's hard not to feel sorry for Reserve Bank of India Governor D Subbarao. For months now, everyone from assorted businessmen to the government has been bearing down on the governor to cut policy rates to provide a helping hand to economic growth, which slumped to 6.1 percent in the quarter ended December.

But so far, the governor has resisted those pressures. With good reason. Inflation remains above the comfort zone for the RBI and there are few signs of prices in the economy going down.

The only way the RBI can slash rates aggressively is if the government reins in its excessive spending and announces measures to boost investments in supply side infrastructure. Reuters

Thursday's latest bit of economic data buttresses that fact. The seasonally adjusted HSBC Markit Purchasing Managers' Index, slipped to 56.6 in February from 57.5 in January. A figure above 50 indicates expansion.

The data showed that input prices are still rising, although the pace has slowed. Manufacturers passed higher raw material costs to consumers, which, in turn, pushed output price inflation to its highest level since March 2011. "These numbers suggest it's premature for the Reserve Bank of India to cut policy rates at the March meeting and that the easing cycle, expected to commence in April-June, will have to be gradual," Leif Eskesen, HSBC economist, said.

Unfortunately, Subbarao might not get the luxury of being able to cut the policy rate- the repo rate - gradually. Inflation, which cooled to 6.56 percent in January after hovering above 9 percent for most of 2011, looks highly likely to surge with a vengeance.

On Thursday, global crude oil prices jumped to $128 per barrel - the highest in 43 months - over rumours of a pipeline explosion in Saudi Arabia, one of the world's largest oil producers. Crude oil is India's biggest import - the country imports 80 percent of its oil requirements.

A weaker rupee will add to the pressure of imports by making oil more expensive in local currency, which could lead to fuel price hikes of up to 15 percent in the new financial year, according to a recent Crisil report.

Then there are food prices. Food prices have fallen dramatically since December, primarily because of a high base last year. That effect will start wearing off soon; an Avendus Securities report released in February warned that food prices could surge to 8 percent by March. In February, food inflation slipped 0.5 percent from a year ago.

The screws tighten

Pressures are building from other parts of the economy as well.

A Mint report earlier this week said Indian Railways might link freight rates to the prevailing price of fuel, which will make it more expensive to transport commodities such as iron ore, coal and foodgrains - and raise prices for consumers. Currently, freight rates are based on distance.

A possible Budget proposal to introduce a 'negative' service tax list, listing those services that will be not subject to tax and, by default, making every other service taxable, will also raise prices of several services throughout the economy.

In fact, if it seems like inflation is cooling over the next few months, it will be because of a high base effect. "Given the strong base effect, we expect headline inflation to continue to print lower in the 6.5-7.6 percent range in the next few months against the 9 percent plus levels seen over the last two years," Citi Investment Research & Analysis said in a note recently, according to a PTI report.

But don't let that fool you into believing that prices are actually declining.

The RBI's hands are tied

With so many pressures building up on the supply side, it's difficult to see how Subbarao can cut policy rates aggressively without stoking inflation.

The central bank has hiked rates 13 times, or by 350 basis points, since March 2010. Yet most economists don't expect rate cuts of more than 100 or 150 basis points in the next financial year (100 basis points = 1 percentage point). Indeed, a recent Macquarie report warned that India could face an 'oil shock' , which could push up inflation again and prematurely stall the rate-easing cycle.

In addition, even if the repo rate is cut, banks will struggle to cut their lending rates given their cost of funds is relatively high, a Firstpost story noted.

The only way the RBI can slash rates aggressively is if the government reins in its excessive spending (the fiscal deficit is expected to exceed 5.5 percent of GDP in the current financial year ending March 2012) and announces measures to boost investments in supply side infrastructure.

If not, we may as well get used to higher inflation, high interest rates and slowing growth for a long, long time.

Updated Date: Dec 20, 2014 08:46 AM

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