Fools rush in

Fools rush in

RBI is right to hold off on rate cuts. Inflation must hit a sustained low first.

Investments had plummeted in the last two years despite lower real interest rates than in the pre-crisis period, which saw an unprecedented investment boom led by the private sector.
Investments had plummeted in the last two years despite lower real interest rates than in the pre-crisis period, which saw an unprecedented investment boom led by the private sector.

Two critical data sets released before Tuesday’s monetary policy review dealt with the second-quarter GDP and October’s CPI inflation. The former, at 5.3 per cent, wouldn’t have come as a surprise to the RBI, since it expects GDP growth to be 5.5 per cent in the current fiscal. But the fast fall in retail inflation and crude prices surprised everyone, stoking demand for an interest rate cut.

The dovish tone of the monetary policy review shows the RBI acknowledges the disinflationary trend. Yet it chose to keep the repo rate, at which it lends to banks, unchanged at 8 per cent. Consumer inflation has been, surprisingly, on the downside, touching 5.5 per cent in October, and could slip further in November, benefiting from the statistical high base effect of last year and slipping crude oil prices.

The drop in inflation does create conditions for a policy rate cut, but given the recent history of stubborn price rise, caution is par for the course. The RBI wants to ensure that inflation will remain sustainably low before it can make the decisive rate-cut moves.

The caution is justified. Inflation fell as good luck, proactive steps by the Narendra Modi government and the RBI’s firm stance on interest rates converged. This will ensure that overall retail inflation will be lower this year than in the last fiscal, despite the inadequate monsoon and marginal improvement in industrial growth.


Let us take the luck part first. Brent crude has slid over 25 per cent from last year’s peak of $115. CRISIL expects crude to average $88-93 per barrel in this fiscal and $77-82 in the next, which is lower than its earlier forecast. This fall, complemented by softening metal and commodity prices, is good news on the fiscal, external and inflation fronts. Inflation in transportation and communication had already fallen below 3 per cent in September-October. Geopolitical tensions will remain a risk, but now softer prices have put an oil-guzzler like India on a good wicket.

Next up are the dynamics of sobering food inflation, which has a 50 per cent weightage in the consumer price index inflation. To be sure, without taming food inflation, it is not possible to sustain low retail inflation rates. For example, if the rate of food price rise stays at 10 per cent, which is the average of the last eight years, non-food inflation will need to come down to 2 per cent to sustaining 6 per cent retail inflation. Food inflation fell to 5.6 per cent in October 2014.

The government has also done its bit by selling grain stocked with the Food Corporation of India when needed, and by showing restraint when raising minimum support prices (MSPs). The MSP increase this year has been only 4.4 per cent, compared to an average 13 per cent annually over the last five years. This and a high-base effect from last year (when vegetable prices flared up in the winter) have driven food inflation down. But to bring it down structurally, more needs to be done to improve agricultural productivity, curb wastage and trim the role of middlemen in influencing the prices of fruit and vegetables.

Even if the RBI had cut its policy rate, its impact would not have been felt fully until the factors that had lowered investment and growth turned favourable again. A CRISIL study, “Will rate cuts spur investments? Not really”, on November 5, 2014, had argued this out. Investments had plummeted in the last two years despite lower real interest rates than in the pre-crisis period, which saw an unprecedented investment boom led by the private sector. The real interest rate was at 2.4 per cent when investment growth plummeted to 0.3 per cent in fiscals 2013 and 2014. That compares with real interest rates of over 7 per cent between 2004 and 2008, when investment growth averaged 16 per cent annually. So the real cost of borrowing was not the main culprit.

Second, falling returns on investments deterred corporates. Today, the average return on investment has dropped to 2.8 per cent from over 6 per cent in the high-growth years. No surprise, therefore, that private corporate investment as a percentage of the GDP had fallen to 10.4 per cent in fiscal 2013 from 15 per cent in 2008. Cost overruns and delays in clearances are what triggered financial stress for many infrastructure projects, not interest rates. Sure, lower interest rates will reduce their debt servicing burden a touch. But till investment risks in these sectors are reduced, the risk premium on loans — and therefore the interest rates — will remain high. Consequently, the private sector will be loath to invest.

It is not easy for any central banker to accurately project the inflation trajectory and the impact of interest rate changes. In 2004, Ben Bernanke, former chairman of the US Federal Reserve, had remarked that if making monetary policy was like driving a car, then that car had an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and late to the accelerator or the brake.

The RBI faces huge information constraints when assessing the speed of the economy as data becomes available after a time lag and is subject to revisions. Forecasting economic data is even more challenging — the gap between inflation forecasts by the RBI and actual inflation in the last few years bears this out.

In other words, even an experienced driver can make a mistake. Ergo, caution is warranted, especially since inflation has regularly overshot the RBI’s targets in the last few years. In October, CPI inflation had dropped 1 percentage point from September to 5.5 per cent, but core inflation remained unchanged at 5.9 per cent. So concluding that prices are firmly under control would be erroneous. The RBI is right in adopting a “better-safe-than-sorry” approach. If inflation stays benign, rate cuts can begin by April. By then, the RBI will also have information on the fiscal performance and targets of the government — key inputs for monetary policy decisions. And hopefully, by then, we will also see formal adoption of inflation targeting by the government, as recommended by the Urjit Patel Committee. That will provide greater clarity on future monetary policy actions.

The writer is chief economist, CRISIL Ltd