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Business News/ Opinion / Why it is too early for another rate cut
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Why it is too early for another rate cut

There are good reasons for the central bank to hold interest rates for now

Illustration: Shyamal Banerjee/MintPremium
Illustration: Shyamal Banerjee/Mint

There are three big issues that Reserve Bank of India (RBI) governor Raghuram Rajan needs to deal with as he prepares to announce the monetary policy review this week.

First, there is a wide divergence in the two main measures of inflation. India has seen wholesale price deflation for eight months in a row. But consumer prices in June were at a nine-month high. The finance ministry has coyly suggested that the RBI should take the direction of wholesale prices into account as well, but the Indian central bank should focus on the consumer prices since it is now officially the nominal anchor of monetary policy.

We should not forget that the central bank made the same mistake after the recovery in 2010. It did not increase interest rates because of low wholesale price inflation even though consumer prices were galloping, putting it dangerously behind the curve. The result was an inflation crisis over the next few years.

It is quite likely that consumer price inflation will come off in the next two months because of base effects. The decline in global oil prices will also help. But consumer price inflation could pick up later if food prices go up. So, there is still not enough reason for RBI to relax.

Second, there is no doubt in our minds that India is now in the midst of a fragile growth recovery. The monetary policy statement in June was made at a time when the India Meteorological Department had just put out its first forecast that the monsoon would be much lower than its average. Most economists also said at the time that a poor monsoon would perhaps be the biggest threat to inflation and growth.

The first two months of the monsoon have been better than expected, so it is quite likely that the economic growth forecast for this year will not have to be lowered. Data such as industrial output, profit growth and bank credit show that the recovery is still weak, but the overall momentum is picking up. India needs a reforms push to raise the growth rate, not a monetary stimulus.

Third, this could be the last monetary policy statement by the Indian central bank before the US Federal Reserve begins to increase interest rates in September. Some emerging market central banks have pushed up interest rates in a bid to protect their currencies in case there is global financial turmoil as US interest rates begin to climb (and let us also not forget the outlier risk of a Chinese financial meltdown). It is well known that the Indian rupee has had remarkable stability in the midst of a global dollar rally. The overall macros look good right now. But Rajan still has to be wary of a sudden bout of global risk aversion, especially if a sharp drop in the rupee threatens financial stability because of the huge unhedged dollar liabilities of many large companies.

Each of these three issues—consumer price inflation, the narrowing negative output gap and the rise of US interest rates later this year—should be read as arguments in favour of holding interest rates at their current level. An additional factor is that the recent decline in global oil prices has perhaps given the government fiscal space to spend more. India is in no position to go in for a monetary stimulus just when there could be a fiscal loosening on the cards.

Rajan does not have much room to cut interest rates right now. There is always pressure on RBI governors to reduce the cost of money—from the government, from companies and from the financial markets. It is not surprising that all three live off leverage.

The RBI is winning an important battle against inflation. The inflation crisis of 2011-2014 had several costs: a run on the rupee in 2013, the shift of household savings out of the financial system and a loss of policy credibility. The Indian central bank should continue to focus on bringing inflation down closer to global levels.

Bolstering growth by bringing the investment cycle back on track is the task of the government right now.

Should the central bank reduce policy rates soon? Tell us at views@livemint.com

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Published: 02 Aug 2015, 08:08 PM IST
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