Should the RBI delay a rate cut?

May 23, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

With the return of inflation, there are doubts whether the Reserve Bank of India (RBI) will go in for the next cut in repo rate any time soon. In April, inflation was up at 7.2 percent, 2 percent more than in March.

What is more disturbing — the food component of inflation was in double digits. With the extreme sensitivity of the RBI to inflation, it is difficult to expect it to take kindly to the fall in industrial production and cut the repo rate.

Food inflation, however, is not the parameter for the RBI to go by because it is outside the impact area of RBI policy. No one buys food by borrowing from the bank and, whatever the interest rate, the expenditure on food will not be reduced and food inflation will not ease.

It is more relevant for the RBI to look at the core inflation or principally, inflation in the industrial sector. No doubt, prices of industrial products have also been rising but at a much slower rate. In April, prices of industrial products were up 1 percent over prices in March. Inflation in the industrial sector was 5.1 percent over the year, well within the RBI’s tolerance limits.

Industry is the major sector that responds to RBI policy. An increase in the interest rate will most certainly crunch investment and a cut, stimulate it. In March, for instance, investment was down 21 percent   because 142 projects involving an investment of 1,553 billion rupees were shelved, being rendered unviable due to the high rate of interest and absence of market for equity.

But the RBI’s single target is inflation. Even on April 17, the cut in repo rate was done quite reluctantly though it was a good beginning. It is critical that it has to be carried forward before it can regenerate investment and revive growth. The RBI had done that in 2008 when the economy had slowed down. The repo rate was 9 percent in 2008 and the RBI cut the rate by 1 percent in October, in spite of inflation raging at 12 percent. That cut was followed by another in November and once again in December. In just three months, the repo was down 2.5 percent from 9 to 6.5 percent, with inflation dropping to 5 percent.

Food inflation and headline inflation are not good signals for deciding interest rate policy. The relevant signal is really the core inflation. If the latter is low, it is necessary to go in for a rate cut even if food inflation is high. A cut in interest rate can save the industry from stagnation. In the absence of any trigger, the repo rate has to be cut in heavy doses and at a fast pace to get it down to 6.5 percent in the next six months. That will take investment back to 30 percent of GDP and growth to 8 percent.

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