Is it time to cut interest rates? Business Standard: 7th March 2012

While inflation is less of a worry than it was in, say, October 2011, monetary policy should take a futuristic view of expected inflation before releasing the pressure”

The present economic environment has a proclivity towards the penumbra of the economic canvas with the latest GDP and index of industrial production (IIP) numbers not really telling a happy story. While the industrial growth numbers will probably improve, we are still talking of a sub-seven per cent GDP growth rate. The worst is possibly behind us and, therefore, there is a case for discussing seriously what the Reserve Bank of India (RBI) should be doing when it announces its policy on March 15.

Should interest rates be lowered? On the face of it, there could be a case for doing so since growth in investment in particular has slowed — capital formation has come down to 30 per cent in Q3 FY12 from a high of 34 per cent in Q2 FY11. Evidently, few companies are borrowing expensive funds since profitability has been lowered on account of high interest cost. But the main purpose for RBI to raise interest rates was to address inflation. Although inflation has moved downwards from the double-digit level to a more tolerable 6.5 per cent in January, there are two considerations.

First, has inflation come to stay at a lower level? The answer is probably a shoulder shrug because prices are still high in all the three segments and it is more probable that the high base effect has statistically brought the numbers down. In fact, month-on-month indices have continued to show an increase for manufactured products, which broadly is the core inflation basket. Therefore, while inflation is less of a worry than it was in, say, October 2011, monetary policy should take a futuristic view of expected inflation before releasing the pressure.

This leads to the second consideration: are prices going to come down next year? The answer, again, is one of ambivalence because the oil crisis on account of Iran can escalate to greater levels and given that the potential is to add one to 1.5 per cent to inflation, RBI needs to tarry. Also, it has to take into consideration the policy stance of the Budget towards fuel subsidy before taking a call on final inflation and the pass-through mechanism. Therefore, lowering rates in March would be premature.

The cash reserve ratio (CRR) decision is easier to take since the market does not see it as monetary easing but as a liquidity supporting measure. The liquidity conditions are quite adverse and a ridiculously large amount is being borrowed from RBI at around Rs 1.7 lakh crore. Clearly the market has been distorted because interest rates should reflect liquidity shortage, which is not happening today. If there was a cap on repo borrowings to the desired extent of one per cent of deposits, there would have been excess borrowing of Rs 1 lakh crore in the call market that would have spooked up rates. This has been eschewed through the use of open market operations (OMO) by RBI to the extent of almost Rs 1.2 lakh crore this year. Therefore, even the text book will say that rates cannot be coming down when the supply of funds is lower than demand since there is little money around.

Earlier, a CRR cut would have been interpreted as being contradictory to the interest rate stance. But today, it is purely a supportive instrument. It will ease partly the liquidity crunch that will be exacerbated by the advance tax payments to be made during the second week of this month. One should recollect that aggressive OMO along with the earlier CRR cut of 50 basis points failed to assuage the liquidity situation, and quite clearly this has to be persevered.

Therefore, in an environment of stringent liquidity that actually should reflect in higher interest rates, and the fear of inflation lurking, a neutral stance on interest rates looks most logical. Rates are still, in effect, low today which would have been warranted by the market conditions. In this scenario it would be better to leave interest rates unchanged until such time as we are confident that inflation is down and liquidity ease to reflect this declining cost of capital.