The reasons for a rate cut by RBI

As core inflation trends down and economic activity remains sluggish, the signs point to a rate cut next week 

 

RBI governor D. Subbarao. The central bank has, on several occasions, made the point that while increases in artificially low administered prices may raise inflation in the short run, they lead to long-term benefits. Photo: Hemant Mishra/Mint  

                     The bad news about wholesale price inflation for February was that it came in a bit above expectations. The good news is that much of it is due to higher fuel prices, and core inflation continues to trend down. The Reserve Bank of India (RBI) has, on several occasions, made the point that while increases in artificially low administered prices may raise inflation in the short run, they lead to long-term benefits.

Lower core inflation indicates businesses have reduced pricing power, which is also indicated from RBI’s survey on capacity utilization during the September quarter of FY13. Capacity utilization was much lower than during the same quarter in the previous three years. With gross domestic product (GDP) growth falling further after the September quarter, it’s very likely that the pricing power of Indian businesses has worsened. The spare capacity will comfort the central bank, since any pick-up in activity as a result of a rate cut will not immediately translate into higher prices.

What of the argument, made earlier by RBI, that high food prices could spill over into higher wages? Won’t the rise in consumer price inflation hold back any monetary policy easing? In a recent speech, RBI governor D. Subbarao said that if “the supply shock is structural in nature and will persist, monetary policy has to respond since persistent inflation, no matter what the driver, stokes inflation expectations.” But he went on to say the government’s embracing of fiscal responsibility will “act as a self-limiting check on the wage-price spiral.” The RBI governor also said that commodity price shocks are unlikely to persist. Crude oil prices are now lower than where they were at the end of January, at the time of the last monetary policy statement.

True, he argued in the same speech that “inflation above 6% would… justify, indeed demand, tightening of the monetary policy stance,” but he obviously looks at the flagging growth momentum too, otherwise he would not have reduced the repo rate in January 2013.

He also argued, in an address at the London School of Economics, that, in the context of sluggish growth, a rate cut need not increase the current account deficit. In fact, he said that a rate cut may lead to higher capital inflows into equities, because investors would see it as “a signal of lower inflation and better investment environment.” Note that there has been an improvement in the February trade deficit.

Economic growth hit a nadir in the December quarter and the latest data do not show much progress since then. RBI data show that bank credit to industry went up a mere 0.8% in January, compared to the preceding month. Bank credit to the services sector declined by 1.1% in January. That indicates economic activity remains extremely sluggish.

In short, the signs point to a rate cut next week. Unfortunately, the rate cut in January and reduction in the cash reserve ratio hasn’t been transmitted to borrowers and some banks have instead increased deposit rates.

Inflation, of course, is far from being merely an indicator of monetary policy—it hits the most vulnerable sections of society the most. The main problem, one that has become entrenched, is high food prices. It’s not just the price of onions, which is a seasonal affair. What about the price of cereals, up 19.2% from a year ago, or pulses, up 15%, or eggs, meat and fish, up 12.9%? This hurts the poor the most, at a time when the growth of the construction industry, the largest generator of jobs for unskilled labour in the recent past, has slowed sharply. But there’s nothing the central bank can do about that.

 

TOUHID HUSSAIN

PGDM 2nd SEM