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RBI cuts rates: Raghuram Rajan and Arun Jaitley are finally on the same page

Reserve Bank of India Governor Raghuram Rajan has finally seen the light. Once seen as an inflation hawk despite his sporadic efforts to ease interest rates, Rajan has, in his latest monetary policy statement today (29 September) traded his hawkish nose for dovish wings. He has cut half a percent (50 basis points) off policy rates, reducing the reverse repo rate to 5.75 percent and the repo rate to 6.75 percent. The reverse repo rate is the rate at which banks park idle funds with the central bank, while the repo rate is the rate at which they borrow from it. This means banks now are being prodded to lend rather than just sit on their money.

The sharp cut in policy rates after a long hiatus is an acknowledgement by Rajan that inflation is well and truly down, even though he does not quite buy the Chief Economic Advisor’s argument that we are closer to deflation territory than inflation. Rajan is clear that we are into disinflation, and inflation is not an immediate threat, thanks to benign global and domestic demand conditions. He acknowledges that “disinflation has been broad-based and inflation, excluding food and fuel, has also come off its recent peak in June.”

 RBI cuts rates: Raghuram Rajan and Arun Jaitley are finally on the same page

Raghuram Rajan

Deflation is a situation where prices actually fall, while disinflation is about a moderation in the rate of rise. The debate on whether we are closer to deflation or merely disinflation will be settled in the coming months by price movements, but Rajan clearly does not want to be accused of pushing the economy towards deflation by doing nothing.

While the finance ministry has been talking about the need for cutting interest rates for several years now – it all started with P Chidambaram’s piquant statement of October 2012 that he will “walk alone” to revive growth even if the RBI will not oblige him on rates - this time Rajan has indeed confirmed that it is his turn to do something. He has acknowledged that the government is more than doing its bit to bring down inflation and revive growth. Among other things, Rajan accepted Arun Jaitley’s commitment to hold down the fiscal deficit and lauded the government’s expert handling of the food economy to beat down potential inflation. Jaitley should be happy with this endorsement of his government’s economic management.

Rajan also indirectly praised the government for reviving stalled projects. He said despite weak aggregate demand, “the expansion in capital goods production…likely relates more to the revival of stalled projects than to a build-up of the greenfield pipeline.”

This monetary policy is also the first one in which Rajan explicitly states that it is time to shift emphasis from a single-minded pursuit of low inflation to accelerating growth. That, he said, was why he had agreed to a 50 basis points cut at this juncture. He said: “Still-low industrial capacity utilisation indicates more domestic demand is needed to substitute for weakening global demand in order that the domestic investment cycle picks up.” (Italics mine)

His most significant statement directly links the need for a monetary stimulus for reviving growth. He said “investment is likely to respond more strongly if there is more certainty about the extent of monetary stimulus in the pipeline, even if transmission is slow. Therefore, the Reserve Bank has front-loaded policy action by a reduction in the policy rate by 50 basis points. Given our year-ahead projections of inflation, this ensures one year expected Treasury bill real interest rates of about 1.5-2.0 per cent, which are appropriate for this stage of the recovery.” (Italics mine).

In the past, Rajan was saying that it was certainty about the trajectory of inflation that was vital for reviving growth; now he is saying that certainty about the direction of monetary policy is vital to revive growth. That’s almost a 180-degree turn for the Good Governor.

Even though Rajan sees the Seventh Pay Commission report as a future fiscal stimulus, he has convinced himself about Jaitley’s sincerity in maintaining the fiscal deficit and its quality. “Under these circumstances, monetary policy has to be accommodative to the extent possible, given its inflation goals, while recognising that continuing policy implementation, structural reforms and corporate actions leading to higher productivity will be the primary impetus for sustainable growth.” (Italics mine)

In other words, ignoring Rajan’s minor caveats, he and the finance ministry are finally on the same page.

The following are the main points and implications of Rajan’s latest monetary policy statements.

First, consumer inflation is under control and well on target for achieving its long-term goals. Rajan said: “Since our last review, the bulk of our conditions for further accommodation have been met. The January 2016 target of 6 percent inflation is likely to be achieved. In the monetary policy statement of April 2015, the Reserve Bank said that it would strive to reach the mid-point of the inflation band by the end of fiscal 2017-18. Therefore, the focus should now shift to bringing inflation to around 5 per cent by the end of fiscal 2016-17.” In August, CPI inflation was 3.66 percent and WPI negative at -4.9 percent.

Second, the RBI is now more comfortable with a fiscal stimulus. Among other things, Rajan was sanguine about increasing public investment to revive growth. Noting that construction was still under the weather, he said “rising public expenditure on roads, ports and eventually railways could, however, provide some boost to construction going forward.” He also implied that the Pay Commission’s likely boost to government expenditure and consumption will not be too inflationary as long as the deficit targets are met.

Third, Rajan is now clear that both the RBI and the finance ministry have to work together – when media reports have talked of a sharp conflict of viewpoints in the past. He said: “While the Reserve Bank’s stance will continue to be accommodative, the focus of monetary action for the near term will shift to working with the government to ensure that impediments to banks passing on the bulk of the cumulative 125 basis points cut in the policy rate are removed. The Reserve Bank will continue to be vigilant for signs that monetary policy adjustments are needed to keep the economy on the target disinflationary path.” (Italics mine)

He’s right here. In January-June this year, Rajan cut rates by 75 basis points, but banks passed on only 30 basis points of cuts to borrowers. Rajan is subtly telling the government that banks will pass on cuts only when they feel more comfortable with their capital requirements and bring bad loans down, but this is an aside. He is now an ally in helping the government help banks. A cut in rates improves bank balance-sheets more than anything else as the value of their investment portfolio perks up as a result.

Fourth, Rajan’s cut of the reverse repo rate is an indirect nudge to banks to lend more for growth. The reverse repo makes it less lucrative for banks to earn money by just parking it with the RBI. At 5.75 percent, this will nudge banks to lend more and take some risks by building their loan books again. Lower interest rates are a prod for action.

Fifth, the rate cuts will – over time – boost corporate profits, and also stock prices. Historically, signals of a lower rate regime have boosted stock prices as internal cash flows get a better discounting from analysts. Debt funds will also rise in value as yields plummet. So both equity and debt funds should do well. It is only new savers who will lose out as deposit rates and yields fall. So the message to savers is simple: lock in to the best rates possible right now to avoid lower rates later.

The ultimate message from Rajan is simple: it is all systems go from the monetary angle. It is over to the government and the corporate sector to continue doing their bit in terms of performance and reforms.

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Updated Date: Sep 29, 2015 16:40:10 IST

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