Rate cut front loaded; eyes  now on data for clarity

In his second bi-monthly policy statement, Governor Rajan has shown pragmatism by reducing the policy repo rate by 25 basis points to 7.25 per cent. The guiding factors for such a reduction include: reduction  of lending rates by banks as a sequel to past policy rate cuts; evolvement of  Inflation along with the projected path of RBI; moderate impact of unseasonal rains; subdued increase in administered prices; and push back of  the timing of normalization of US monetary policy. To quote Dr. Rajan, “With low domestic capacity utilization, still mixed indicators of recovery, and subdued investment and credit growth, there is a case for a cut in the policy rate today.”

A perusal of the current global economic development reveals that the recovery is not only slow but is getting increasingly differentiated across regions. The firming up of crude oil price is a matter of concern for oil importers like India. Domestic economic activity, particularly the agricultural activity, presents a worsening situation, especially with regard to pulses and oilseeds, where buffer stocks are not available and thus are a potential threat to inflation in the medium term. Even though retail inflation has moderated and there has been some softening of food inflation, the uncertainty regarding a normal monsoon could pose upside risks to inflation and inflation expectations. It is important to note that inflation expectation is already high. Furthermore, firming up of crude oil price poses down side risks for containing current account deficit at a sustainable level.

In the above context the moot question, is when the global and domestic developments have not been supportive of a rate cut at this juncture, would it not have been better to follow a policy of ‘wait-and-watch’?

While going for a rate cut to stem some of the increasing criticism, the Governor has, however, set out the downside risks to inflation arising from uncertainty in normal monsoon, volatility in crude oil prices and volatility in the external environment. To quote Dr. Rajan “A conservative strategy would be to wait, especially for more certainty on both monsoon out turn as well as government response to reduce supply constraints over the medium term to stay on the proposed disinflationary path (to 4 per cent in early 2018), however, a more appropriate stance is to front load  a rate cut today and then wait for data that clarify uncertainty.”

It is important to recognize that a policy rate cut is not an end initself; it is a means to an end. In order to contain inflation along with inflationary expectations, it is imperative that government should have a strong food policy as also food management. The government should have contingency plans for food management, which include storage of adequate quantity of seeds and fertilizer for timely supply, crop insurance schemes, credit facilities, timely release of food stocks etc. Further, limiting the increase in agricultural support prices would also help inflation control. Thus, food management will be critical in guiding the future inflation path.

To sustain higher growth rates, with a low and stable inflation of 4 per cent in the medium term, it is appropriate that government policy should focus not only on enhancement of public investment, but also on encouraging private investment. This in turn requires that the government follows strong fiscal consolidation and eliminates revenue deficit by 2017-18, so as to boost domestic saving. At the same time, this would facilitate garnering resources for public investment including infusion of capital in public sector banks, so as to ensure adequate credit flows to productive sector.

With the RBI taking the lead through initiating the policy rate cuts, the agenda for the government is clear. The government should improve food availability through prudent food management and concentrate on consolidating the fisc. Banks should pro-actively pass on the policy rate reduction to reduce the lending rates. More importantly, the corporates should focus on improving their balance sheets, especially those items that are independent of policy rate.

* The authors are Professors of Economics at the S.P. Jain Institute of Management & Research, Mumbai. Views are personal.

R.K. Pattnaik & Tulsi Jayakumar

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