The RBI chose not to reduce interest rates in its latest credit policy. Rates were left unchanged consistent with the view that the slowdown in credit growth,in some inflation measures and in the economy,suggest there is no longer a case for further tightening. However,at the same time,the RBI did ease the liquidity situation since there has been an almost chronic shortage of credit with banks borrowing more than 1.3 to 1.4 trillion rupees from the RBI from the repo window. This policy move is the right one since it is not clear that inflationary expectations or core inflation has come down adequately for the RBI to start cutting rates.
While there is an increasing amount of evidence showing a slowdown in GDP growth compared to the period in which there was a clear upswing in the business cycle,there is no clear evidence that the spiral of inflation is over. The danger in a situation like this is that if the central bank eases rates too soon,and there is a wage-price spiral which pushes costs of production up before inflation is clearly out of the system,the economy could get into a stagflation which then becomes nearly impossible for a central bank to tackle quickly. In that situation,when growth is slow and inflation is high,the central bank is faced with no good choices,it can neither raise rates nor lower them. The RBIs policy should be to not start cutting rates until it is absolutely certain that the general public believes inflation is down to 4-5 per cent,and when salary negotiations for next year are based on such inflationary expectations. At the moment,food inflation has come down. If the cost of living does not rise rapidly and the public believes the RBI is committed to keeping inflation low,then inflationary expectations will come down. This would be the time to start moving down on the rate cycle.
In the coming quarter,the RBI is likely to face increasing pressure from media,industry and perhaps the government to cut rates. The RBI governor needs to stand firm,and deliver the only thing a central bank can really deliver: a commitment to low and stable inflation. Often arguments can be heard that growth would rapidly pick up if interest rates were lower. Yet,it is quite obvious that there are many,many aspects of policy standing in the way of higher investment. These need to be solved by the government as soon as possible so that the pressure on the RBI to reduce rates,in a period of high inflationary expectations,comes down.