A delayed rate cut

The RBI has positively surprised markets by announcing a 50 basis points (bps) reduction in the repo rate.

As we were getting close to the final countdown before the annual monetary policy announcement for 2012-13, the odds between the central bank easing policy rates by 25 bps and keeping rates unchanged were equal. The RBI had earlier taken cognisance of the growth slowdown but preferred not to cut rates as it was not sure of the inflation trajectory.

Growth was strangulated in 2011-12 by adopting a more than required tight monetary policy stance when deceleration was clearly visible in the economy.

The cut in policy rates by 50 bps should be seen as the RBI making up for lost ground.

In a way, the central bank preferred to play safe so that its March 2012 inflation target of 7 per cent can be met. The bold easing of the policy rates was guided by the decline in core inflation to below 5 per cent in March 2012 after a gap of two years.

Easing, though by a smaller 25 bps, should have been initiated in the fourth quarter of 2011-12 which would have impacted the second quarter of 2012-13.

Now that the easing has begun around the middle of the first quarter of 2012-13, the positive impact on growth has been delayed.

The rate cut, if not anything else, will act as a sentiment booster.

It will help small and medium firms that operate on the fringe and will help banks to contain their NPAs. However, it will take some time before banks begin to lower their lending rates as such decisions will be governed by their cost of funds which, in turn, will be guided by the evolution of liquidity conditions.

Inflation target

Higher growth is analogous to a rising tide which lifts many boats.

The monetary policy measure announced on Tuesday is supportive of private investment.

However, the growth trajectory will be ultimately governed by complementary fiscal policies and structural reform measures to ease supply-side constraints.

If the Government allows the prices of petroleum products to be aligned with international prices, it will have inflationary implications. If the Government decides to absorb the rise in prices, the fiscal deficit will shoot up, which, again, will not only be inflationary, but will also crowd out private investment and affect growth adversely.

The RBI has projected for a WPI inflation target of 6.5 per cent for March 2013.

This target appears ambitious as there are significant upside risks to inflation in the economy.

The 50 bps cut perhaps is recognition on the part of the central bank that further rate cuts will be few and far between, unless growth decelerates significantly.

(The author teaches Economics at the Xavier institute of Management, Bhubaneswar. )

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