There are many, especially in the industry and government, who are rooting for a higher interest rate cut of 50 basis points when RBI governor Raghuram Rajan announces the Reserve Bank of India's (RBI) credit policy next week. They argue that sustained lower inflation, the US Federal Reserve's decision to hold on to interest rate hikes till December and slowing industrial growth offer the right environment for a rate cut. However, that is being too optimistic, since the governor will take into account the long term impact of these factors before any bigger-than-expected reduction in interest rates.
Retail inflation stood at 3.66 per cent in August, marginally down from 3.69 per cent in July. However, the rate of food price rise went up from 2.15 per cent to 2.20 per cent. Prices of food items, including that of pulses and vegetables such as onions, are still reigning high. Inflation is expected by many to move up in the coming months. "August marks the month when the high base effect from last year begins to wear out, suggesting a possible upward trajectory for inflation hereon," says ratings agency Crisil in a report. The rising rainfall deficiency is also a problem, and can hurt the rabi (winter) crop, negating some of the gains from lower fuel prices, keeping inflation on the higher side.
The flow of foreign capital to emerging countries is continuing, despite the wild fluctuations one has witnessed in the recent past. In a recent interview in the US, Rajan has said that capital keeps getting attracted to "strong economies" and influences RBI's decisions on interest rates. Although there have been some strong outflows from the equity markets, the growth potential is strong, seems to be Rajan's view. In that case, he would continue to be conservative in lowering the interest rates.
The US effect
The recent Federal Reserve (the US central bank) decision not to hike interest rates has provided some sense of relief to markets in emerging economies. However, that does not warrant a rate cut, since many believe that the Fed has to ultimately hike the interest rates, even if delayed. Rajan is of the view that an interest rate hike by Fed during a highly volatile period may have proved counterproductive, and therefore it desisted from doing so. However, the US central bank will have to do it, eventually.
Rajan has time and again demonstrated that he is against any window dressing moves, but would prefer to go by fundamentals of the Indian economy to frame the monetary policy. At a recent talk in Mumbai, he said that what he expected from the business community was not "'impatience and pressure for quick impossible fixes" but understanding and cooperation. He cited the example of Brazil which lowered its rate even as the economy was growing at a healthy seven percent, leading to a credit spree and over-spend, resulting in high inflation and slow growth later on. The message is clear. Nothing can move Rajan to reduce rates except the economic fundamentals. And he is determined to continue his war on inflation, even if the industry cries it hampers growth.
However, a case for rate reduction still holds strong. Industrial production growth moderated to 4.2 per cent in July from 4.4 per cent in June. The picture for manufacturing was also less positive with growth slowing to 4.7 per cent in July. Growth in domestic sales of automobiles declined to 1.4 per cent in July, down from 2.6 per cent in June. Bank credit growth for consumer durables remained low (at 3.9 per cent) in July with vehicle loans recording growth of just 4.8 per cent despite the repo rate coming down by 75 basis points since the beginning of January Rajan, therefore, is likely to oblige with a 25 basis point reduction in rates, the fourth such reduction this calendar year.