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Reserve Bank of Indias surprise rate cut puts its long-term credibility at risk

The Indian financial markets rose handsomely on the very positive


news of a surprise 50 basis points cut in the policy rate by the
Reserve Bank of India (RBI) on Tuesday.
Among others, the price of 10-year government security moved
higher, with its yield falling by about 17 basis points over the
following 48 hours.
In financial markets, as in life, surprises are rare, by definition. Major
central banks, with the exception of the Peoples Bank of China,
perhaps, tweak their policy rates by 25 basis points at one go on most
occasions.
A 50-basis point rate cut can happen under either of the following
circumstances:
One, when a central bank comes to the conclusion that it should
have cut the policy rate more in the past, particularly in the last
review. And, therefore, it seeks to make amends for the missed
opportunity. By doing so, the central bank wants to be sure that it
is not left behind the curve to use jargon.
Two, when fresh data coming out since the last review clearly
demonstrate that the economy is on a steep downward trajectory,
particularly in terms of output, inflation and employment.
Clearly, a decision to cut the policy rate by 50 basis points must be
backed by a whole host of relevant data and serious analysis.
RBI expects CPI inflation to be a shade better than the target of 6 per
cent by the end of the current fiscal and would strive to bring it further
down to 5 per cent in fiscal 2017-18.
Inflation expectations, both for the short- and long-term continue to be
high. Growth projection for the current fiscal at 7.4 per cent, though
slightly less than 7.6 per cent projected earlier, is still impressive
reflecting the recovery underway.
The monetary policy report clearly states, Services inflation has
been more persistent relative to goods inflation.
The cost of education and healthcare have been growing at double
digit rates hurting the middle class as well as the pensioners, and it is
here the inflation expectations get hardcore.
The governments fiscal position is unlikely to improve for the better
in the near future, what with more payouts on account of OROP (One
Rank One Pension) and the 7th pay commissions recommendations.

One wonders, how a strong accommodative signal is conducive to


achieving disinflation, particularly when inflation expectations
remain high and more or less unchanged since the last review in
April, 2015?
Real interest rate, if calculated on the basis of expected inflation as
revealed in surveys (and not what RBI expects) will be much below
1.5-2 per cent range (actually negative), as envisaged by RBI.
Since the last review, one has come across strong opinions on the
need to lower rates with India Inc. projecting as if the interest rate is
the only determinant of their investment decision and the
governments chief economic adviser highlighting that India may be
headed towards deflation based on WPI readings, implying high
interest rates are throttling growth.
Governor Rajan, who took the reins of RBI in 2013 at a time when the
rupee was in a free fall, had won the confidence of international
investors that RBI will be committed to rules driven policy making
with utmost transparency.
The average CPI inflation between 2006 and 2013 was 9 per cent and
although several other factors contributed to lowering of inflation
subsequently, Dr. Rajans role in establishing the credibility based on
sound inflation targeting monetary framework was the cornerstone for
the new course charted for Indias macroeconomic policy.
In 2015, Dr. Rajan runs the risk of losing this hard-earned credibility
by yielding to market appeals for lowering rates. It will take a longterm credible commitment from RBI to low and stable inflation rather
than sharp shifts in policy to spur growth.
Central bankers in advanced economies have been trying to use
monetary policy to substitute for the lack of implementation of hard
structural reforms and painful adjustments by their governments. It
will not work. Hopefully, Dr. Rajan does not emulate his peers in
advanced economies and sticks to the core mandate of price stability
and independence of monetary policy decisions.
One often hears that the long-term vision of Dr. Rajan is to set the
stage for sustainable high growth for India with structurally lower
inflation, and with less dependence on subsidy and largesse and
discretionary intervention in the financial sector. This vision must
remain intact and be pursued consistently.