Story Of The Week

NO RATE CUTS – WHY RBI IS STILL WAITING?

Amid all the speculations  and debates regarding whether to ease the monetary policy or not, RBI Governor, Mr. Raghuram Rajan, kept the interest rates unchanged for the fifth time in a row. But he also signaled a probable rate cut early next year.

This was an expected move as RBI had few strong reasons to wait before taking this step. Yes, inflation (CPI) has fallen to 5.52% in October 2014, due to falling prices of crude oil and food items becoming cheaper. The import bill has reduced which in turn has lowered current account deficit to about 2% of GDP from 4.8 % the previous year. This shows good signs, but there is another side to it. The drop in inflation is due to change in base year from 2004-05 to 2011-12. So we are still not sure if these figures mirror the actual reduction or not. Moreover, the export orders have been holding up. This is not a major issue right now but in future, if exports become slower, CAD will be affected.

Uncertainty regarding probable rate cut was because of pressure from Finance ministry to reduce rates. For ‘MAKE-IN-INDIA’ campaign to be successful, the government requires large amount of foreign investments inflow. For this, it is required that RBI cuts rates, which gives room to commercial banks to offer attractive investment options to the foreign companies.

Another reason for not reducing rates is the pending correction in the stock market. Indicators like consensus earnings estimate for the Standard and Poor’s 500 stock indexes and Cyclically Adjusted Price to Earnings multiple (CAPE) have been signaling of lately, that the market is overvalued. If RBI infuses more liquidity in the economy at this point of time, investment in stock market is likely to go up, and if then, due to many other factors, the market takes a down turn, the economy will suffer from a great crunch.

Views of Mr. Rajan and the government seem to be on the same side and not opposing each other. With healthy discussions and persuasion, Mr. Rajan has made government to agree that prime objective of RBI is to contain inflation to 4%, ± 2%. This will help reduce the dependency on interest rates as an instrument to manage economy and currency.  RBI is in no hurry to provide short term stimulus to growth. Rather it’s more focused on keeping inflation under control for larger good.

Need of the hour is formulation of a system that checks inflation in presence of lower rates and makes monetary policy more effective. Long awaited coordination between fiscal and monetary policy can be seen with new government and RBI working in tandem.

Now it is being speculated that RBI would cut interest rate by 50 to 75 base points by March 2015. But if global commodity price trajectory reverses in early 2015, then all the opinions on rate cut are off. Therefore, the best bet is to wait and watch and not lose faith on the sanity of RBI governor and the government policies.

REFERENCES

1) Dalal Street hopes its RBI guess is right – Business Standard

http://www.business-standard.com/article/markets/dalal-street-nervous-on-rbi-policy-review-114112900526_1.html

2) Is stock market correction pending? – Stillman Exchange

http://thestillmanexchange.com/2014/10/23/is-a-stock-market-correction-pending/

3) Rajan stays firm on rates – The Economic Times

http://epaperbeta.timesofindia.com/Article.aspx?eid=31816&articlexml=Rajan-Stays-a-Firm-Warrior-in-Inflation-Battleground-03122014001028

4) Rajan’s interview – The Economic Times

http://epaperbeta.timesofindia.com/Article.aspx?eid=31816&articlexml=QA-Well-Gain-Confidence-in-Our-Models-Over-03122014018023

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