Will the central bank go for a rate cut?

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The Wholesale Price inflation rate in August rose to 7.55% on higher food and energy prices against a 32-month low of 6.87%. The price rise was higher than what most analysts had expected. What is more worrying is the fact that so-called core inflation, or non-food, non-oil, manufacturing inflation, rose 5.58% in August, compared with 5.45% in July.
In normal circumstances, a rate cut by the Indian central bank is ruled out even though Asia’s third largest economy is slowing. But I would like to believe the Reserve Bank of India (RBI) may go for a rate cut to send a signal to the market, if not for anything else.
The last week has been dramatic by any yardstick. On Wednesday, many believed RBI might oblige the industry lobbies that have been aggressively asking for a rate cut as India’s factory output rose just 0.1% in July as mining and manufacturing contracted and electricity production grow at a mere 2.8% against 13.1% in July 2011. This was after the Index of Industrial Production had contracted 1.7% in June. In the first four months of fiscal 2012, between April and July, the contraction has been 0.1% against 6.1% expansion in the year-ago period. Capital goods contracted 5% in July and, barring February, this segment has been contracting for 11 months in a row, making it abundantly clear that there is no investment demand.
In this backdrop, it was not entirely wishful thinking that RBI should step in and cut its policy rate to bring down the cost of money and prop up a sagging economy. But the August inflation data, released on Friday, changed the scenario, making it extremely difficult for the central bank to justify a rate cut.
Despite that, I am betting on a rate cut because the government finally demonstrated its resolve to manage the fisc. A week after the disinvestment department of the finance ministry invited bids from investment bankers to manage the sale of government stake in three state-run companies, the coalition government raised the price of diesel, capped the supply of subsidized cooking gas, opened up the retail and aviation sectors to foreign investments, and cleared divestment of government stake in more public sector undertakings. All these announcements were done in the face of stiff resistance put up by the United Progressive Alliance-led government’s coalition partners and risking its survival.
The hike in diesel price, if the government sticks to its guns, will raise inflation by 60 basis points (bps) in the first round. A basis point is one-hundredth of a percentage point. In the second round, as the diesel price hike will have its impact on the cost of transport, and hence goods and food items, inflation will rise more. By the end of the year, wholesale price inflation could be as high as 7.5%, 50 bps higher than RBI’s revised year-end inflation estimate. Its initial year-end inflation estimate was 6.5%.
Still, RBI should go for a rate cut as the government has met its demand by attempting to make fiscal corrections and, in the process, restored the credibility of the central bank. RBI governor D. Subbarao has all along been saying that the monetary authority alone cannot be held accountable for putting back the economy on a growth path; the government needs to extend a helping hand by cutting down subsidies and making fiscal corrections. Now that the government has done its bit, Subbarao should reciprocate by paring the policy rate. Of course, he can always say the government itself is reciprocating RBI’s action in April, when it cut the policy rate 50 bps to 8%.
If he indeed does so, he runs the risk of losing credibility.
It’s time for a concerted move to arrest the slowdown and prop up the investment climate. Even though inflation continues to remain high and can even get higher, RBI now needs to gamble on growth by paring its policy rate. Even if wholesale price inflation remains at 7.5% by the year-end, RBI has a window of a 50 bps rate cut. In other words, it can bring down the policy rate to 7.5% and still keep it neutral.
The question is: will it stagger the rate cut or go for a 50 bps cut on Monday to make it more effective? Even if it does not opt for a deep rate cut, at least a 25 bps cut will send the signal that the central bank means business.
At this point, there may not be any need to cut the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with RBI. The cash deficit in the system will rise this week and may cross Rs.1 trillion because of the outflow of advance tax, but money will come back to the system as the government will spend. Indian corporations pay tax on their estimated profits every quarter.
Barring this week and probably the week after, the cash deficit in the system will remain within 1% of bank deposits, which has been the stated stance of RBI. Once banks start cutting their base rate or the minimum lending rate after a policy rate cut, and corporate borrowers start borrowing money from banks, RBI may have to cut CRR. But that won’t happen too soon. The need of the moment is a cut in policy rate.
Tailpiece
Reacting to my last week’s column, a central banker pointed out that indeed the banking system is not in the best of health and bad assets are rising, but the difference between the late 1990s and 2012 is that Indian banks have more capital now and hence do not need to worry. Point well taken.
But the banks should not claim any credit for this. The government made it a point to infuse capital in state-run banks in the aftermath of the collapse of US investment bank Lehman Brothers Holding Inc. The banks are now reaping the benefits of recapitalization.

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