RBI certainly has a tactical task ahead during its coming policy review, to balance its emphasis on inflation targeting versus acknowledging the medium- to long-term positive impact of the spate of measures announced by the government, most of which await parliamentary clearance for implementation.
Our economy is traversing a rough patch, witnessing persistent inflation, a rising fiscal and current account deficit, high currency volatility and weakening output growth. Regulatory uncertainty and policy gridlock have battered foreign corporate investment over the past year, adding to dramatic slowdown in growth. Global economic conditions have not changed materially. US indicators have improved but the implied pace of expansion remains moderate and the fiscal cliff looms. In Europe, the real economy has continued to weaken and more details are awaited for fiscal and banking union.
Macro data points have not shown any comfort to the central bank. Inflation has remained elevated. Recent fuel price rises, increase in rural and farm wages (growth of 19 per cent over a year as of August 12), with no corresponding increase in productivity and loose fiscal policy are expected to add to inflationary pressures in the coming months. The trade balance widened in September to $18.1 billion (11.9 per cent of GDP) from $15.6 bn (10.3 per cent of GDP) in August, with exports declining 10.8 per cent over a year while imports had grown (mainly on account of oil) by 5.5 per cent. On the fiscal deficit, the central government expenditure growth has remained high at 19.7 per cent, well above budget estimates of 14.8 per cent.
The reforms announced over the past month have improved investor sentiment but haven’t helped reverse the near-term demand-supply dynamics. The only immediate relief is on account of the rupee’s strengthening. The government has repeatedly stated, in the short run, the sum totals of its actions are aimed at reviving animal spirits and re-igniting the economy. But, has insisted a softening of interest rates is a key prerequisite to reviving these spirits and calibrated risks need to be adopted at this moment.
While macroeconomic indicators do not justify a cut in the repo rate, if RBI is convinced the government means business this time and is serious about fiscal consolidation, alleviating infrastructure supply constraints, coupled with further policy reforms, the central bank will be slightly more sanguine about growth-inflation dynamics.
In this context, we believe RBI could look at the possibility of a 25-basis points cut in the Cash Reserve Ratio, with a commitment to keep adequate system liquidity, and a 50 per cent chance to deliver a 25-bp repo rate cut as a gesture of reciprocity to the recent government actions, though the fundamental problem is that inflation risks are still to the upside. Cutting the policy rate under these circumstances runs the risk of unhinging inflation expectations.
(The author is head, global markets group, IndusInd Bank)