The monetary policy has always been a balancing act. The act only got tougher in the last few years when growth fell below potential but inflation did not come down commensurately. The Reserve Bank of India (RBI) has maintained that room for rate cuts is limited due to high inflation, which I believe will remain so until inflation comes down to around 5 per cent on a sustainable basis.

At present, the economy’s growth is trailing the potential and this trend is unlikely to change/reverse (growth potential is estimated at around 7 per cent) in 2013-14. Against this backdrop, it would be prudent to utilise the existing room for rate cuts by front-loading them. The rate cut could be afforded at this juncture for the following reasons:

The WPI inflation fell to a 40-month low of 5.96 per cent in March 2013. The slide in inflation was accelerated by fall in global crude and commodity prices.

Therefore, despite increases in diesel and electricity prices, overall inflation came down faster than expected.

The CPI inflation too is expected to decline from current levels of around 10 per cent.

The fall in inflation can also be attributed to the reduced pricing power of companies. The weakening demand pressures are reflected in the sharp fall in core inflation to 3.5 per cent in March 2013.

There has been significant demand destruction in 2012-13, which is bringing down core inflation with a lag.

Private household consumption spending, at 57 per cent of GDP, has held up quite strongly in the last few years, growing at a real average rate of around 8 per cent per year during 2004-05 and 2011-12.

Even the global financial crisis did not dent it much. Real growth in private household consumption spending fell only marginally to 7.2 per cent during the peak of the crisis in 2008-09 and swiftly regained its pre-crisis trend of 8 per cent per year over the next 3 years. Only in 2012-13 did private consumption growth halve to 4.1 per cent.

This sharp reduction has affected the ability of corporates to pass fully pass on input costs to customers, particularly in discretionary spending areas like consumer durables.

As consumption demand is unlikely to lift significantly in 2013-14, its pressure on inflation will be muted. And, lastly, the fiscal consolidation initiated by the Government sends positive signals to RBI.

All these factors made today’s rate cut possible. So while another rate cut cannot be ruled out, it will only happen if the inflation remains soft.

(The author is Chief Economist, CRISIL)

Also read: Are rate cuts the way to go? - NO

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