RBI policy today: Pressure builds up on Raghuram Rajan to cut rates but he may not budge

Odds are largely in favour of governor Raghuram Rajan keeping the key interest rates unchanged at the Reserve Bank of India’s (RBI) bi-monthly policy review today. For one, between last bi-monthly policy review and this, data points have indicated continuation of vigil from the central bank on the inflation front. The two rounds of retail inflation numbers have shown an increase in the price levels, especially vegetables and food items. Consumer Price Index (CPI) rose to 5.01 percent in May and further to 5.4 percent in July, which is an eight-month high. CPI food inflation and vegetable inflation too rose in July from 4.8 percent and 4.64 percent, respectively, in the previous month. A deficient monsoon will only make the price situation worse. In the 2 June policy review, governor Rajan had made it clear that the behaviour of monsoon will be a critical factor for the central bank to decide on the course of interest rates going ahead. [caption id=“attachment_2377734” align=“alignleft” width=“380”] The IMD has not changed its drought forecast yet. Reuters[/caption] The Indian Meteorological Department (IMD) has retained its drought forecast despite some improvement in rain distribution across the country. The department had earlier forecast the rainfall at 88 percent of the long-period average (LPA), due to a strengthening El Nino weather pattern. There are fears that the rains in August-September are likely to be 84 percent of LPA, raising fears the country may face the first drought in six years. Deficient rains can spike food prices, as nearly half of India’s farmland lacks irrigation. Second concern for the RBI has been the poor transmission of its rate cuts. The central bank has already reduced the policy rate by a total of 75 basis points thus far in 2015. Early this year, the RBI had listed transmission of these rate cuts as a pre-requisite to for further easing. Though some banks have begun cutting lending rates in the recent months, the rate actions have been limited to 25-30 basis points. Most of the banks, which have cut rates this time, hadn’t done in the previous rounds and was merely adjusting their base rates to the industry. The central bank might want to see some more transmission happening before lowering rates further. Thirdly, many economists foresee a likelihood of retail inflation inching up beginning September on account of the fading base effect. Under the current policy set up, the central bank has to keep inflation within a limit of 6 per cent and would not want to take no risks by stimulating demand through further rate cuts at this stage. Pressure on Rajan While these are reasons that should logically prompt the central bank to keep the rates on hold, there is immense pressure building up on Rajan to cut rates regardless of the signals emerging from the retail inflation front. On Monday, the PTI quoted a finance ministry official as saying inflation shouldn’t be a reason for the RBI to not cut rates since lower commodity prices and negative wholesale inflation gives room for rate cut. Industry lobbies have also pitched for a quarter percentage point rate cut citing delayed economic recovery. Also, growth indicators haven’t signaled signs of sustainable economic recovery so far. The May factory output numbers reported a dismal performance dropping to 2.7 percent from 3.4 percent month on month, which has strengthened the calls for a rate cut. But as Firstpost has been highlighting, monetary policy can do no better job to boost economic revival than much-needed reform measures to bring in private investment. Nevertheless, there is pressure building up on Rajan to cut rates. Going by the language in the last policy, the RBI still perceives more upside risks to inflation than until sometime back when it raised the inflation target to 6 percent from 5.8 percent for the year end. The question is will Rajan stick to his cautious approach or bow to the pressure of the rate cut lobby? The first one looks more likely.