US Fed paves way for Raghuram Rajan to cut rate but inflation worries will limit headroom

The US Federal Open Market Committee's decision (FOMC) to hold its key rates unchanged, for now, gives another reason to Reserve Bank of India (RBI) governor, Raghuram Rajan, to lower the central bank’s key rates in the September 29 policy review.

Going by the language of the FOMC, a rate hike is still a possibility later this year if the macro economic scenario in US picks up and global growth improves.

 US Fed paves way for Raghuram Rajan to cut rate but inflation worries will limit headroom


A major reason why Janet Yellen chose to hold the rates is the current global turmoil, mainly in the Chinese economy. There are economists and fund managers who do not expect a rate this year.

For the Indian central bank, most of the factors that should influence it to go for a quarter pecentage point rate cut or even a half a percentage point (if the RBI wants to front-load the rate dose and stay on hold thereafter), are in favour.

Both wholesale and retail inflation rates have come down in the recent months, industrial growth has showed some pick up, the government has showed some willingness to begin public infrastructure spending and now the US Fed too has given breathing space for it to act.

But, as Firstpost noted before in an article, chances for a big dose of rate cut boost is unlikely since the central bank would be simultaneously cautious on the upside risks in the economy. The central bank is likely to list the upside risks in its forthcoming policy statement, while announcing a rate action.

These include,

One, inflation, though trending down, is not dead yet.

Food inflation remains sticky and the prices of essential items haven’t come down on the ground.

The RBI would want to assess the full impact of a poor monsoon (forecast 12-14 percent less) on prices of vegetables and essential items. Also, there is a possibility of retail inflation inching up from September when the benefit of base effect fades.

One must note that inflation management remains as the primary priority of the Indian central bank. On Friday, Rajan reiterated this stance saying RBI'S intention is to kill high inflation for the long-term, not just in the short term.

"The differential between WPI (Wholesale Price Index) and CPI is a source of problems. We have to be careful while pursuing growth and have to make it sustainable. The key is to keep inflation low not just today, but also in the future," Rajan said.

Rajan's comments make it abundantly clear that the central bank wouldn't be ready for a big gamble sabotaging it's own efforts to contain the dangers of inflation in the economy. Rajan might heed to the calls from north block and cut rates by by a quarter percentage point now and might stay on hold thereafter.

Two, the Fed rate hike still remains a possibility in the foreseeable future, most likely this year itself, even though the FOMC has held the rates for now. It is anybody’s guess when the Fed will hike rates especially given Janet Yellen’s comments that “every meeting is a live meeting”.

The FOMC statement keeps the option alive to raise rates as and when economic situation improves.

"The committee anticipates that it will be appropriate to raise the target range for the federal funds rate, when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term," the statement said.

For the RBI, which faces mounting pressure from the government to cut rates, it would make more sense to go for the rate move now than two months later, when the Fed gets closer to the rate hike.

A possible rate hike by the Fed can cause a capital flight from emerging markets including India since global investors considers these markets risky.

India would not be an exception even though the impact here will be less severe this time than in the past since the macro economic health of the country is in a better shape with current account deficit under control, inflation lower and some pick up in growth visible.

For now, the Fed has given a green signal to the Indian central bank to go for another rate cut.

(This article has been updated to add Raghuram Rajan's comments)

Updated Date: Sep 18, 2015 14:31:03 IST