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BW Businessworld

Low Growth, Slow inflation, No Rate Cut

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John Pierpont Morgan, legendary American banker, had it right. When you expect something to happen, he said, strangely enough, it does. Most people were resigned that the Reserve Bank of India (RBI) would not cut the repo rate – the policy rate at which banks borrow from the RBI – and the central bank obliged.

The rationale for the RBI’s staying put on its monetary policy stance was widely debated even before today’s mid-quarter policy review.. ‘Headline’ inflation – as measured by the wholesale price index (WPI) is declining, as is ‘core’ inflation (headline inflation minus that in food and fuel, which are quite volatile). But consumer price inflation isn’t, and stuck at about 9.5 per cent.

The RBI’s policy statement points to external factors and the current account deficit as big drivers of the policy stance of not cutting rates; because of the trade imbalance, the rupee has depreciated by nearly 7 per cent in the last three weeks.  With a depreciated currency and a persistent and high trade deficit, imported inflation becomes a threat.

The other guidepost for the central bank — inflation being the first — is growth, and while that is a big concern, it’s still 5 per cent (well below the potential 8 per cent it could be). Blame part of the problem on the slow process of monetary policy transmission: in other words, past rate cuts have not been passed through to industry, which the RBI admits to being worried about.

Read Also: Rupee Falls After RBI Keeps Rates On Hold

As the RBI’s policy statement also points out, global growth hasn’t been great either: the US recovery has been slower than anticipated, so American demand for our goods and services, which drives our growth in both sentiment and fact, will slow. Europe is still very focused inward, so expect o help from that quarter.

But If the value of the rupee is going to become the principal factor in not cutting interest rates, then we may be in for more trouble than we think. Here’s why.

The US Federal Open Markets Committee (FOMC), the US monetary policy-making body meets tomorrow and Wednesday (18 and 19 June), and three questions dominate financial markets debate on the outcome of the meeting: will quantitative easing, or QE3 taper off, as US Federal Reserve Board chairman Ben Bernanke suggested before the US Congress? When will the tapering off begin? By how much?

Currently, the US Fed’s bond buying programme (the form of QE used) is about $85 billion a month; that keeps the economy growing at about 2.5 per cent, though unemployment at 7.6 per cent against a target of 6.5 per cent, has been much slower to achieve. The good news: inflation in the US is at less that 2 per cent. The fiscal side cannot spend because of the sequester, or automatic spending cuts that came into play because the Congress and President Obama couldn’t reach agreement on the federal budget.

Similar as it is to the Indian situation — low or falling inflation, combined with lower than expected growth — the US today looks very like the US in 1994, when a face-off between then President Bill Clinton and a Republican Party dominated Congress shut down the Federal government: again, the fight was over budget cuts and fiscal discipline.

But in February 1994, fearing the return of inflation, Alan Greenspan’s Fed suddenly began to raise interest rates – the Fed funds rate, much like our repo rate – for the first time in 5 years; it went on to raise the Fed funds rate over and over for 10 months, a thereto unprecedented increase of 2.5 per cent.

US analysts have been comparing the two periods, and wondering if the same thing could happen (along with or instead of a tapering off). The net effect would strengthen the dollar against other currencies, and depreciate the rupee even further: some extremist views put it at between Rs 65-70 to the dollar, should that happen.

Back within our own shores, businessmen are suggesting that no rate cut is the equivalent of a rate hike when currency depreciation is included in the calculus. Granted, the RBI has little choice but to stick to the status quo. But as Bob Iger, chairman of The Walt Disney Company once said, “the riskiest thing we can do is just maintain the status quo”.