Apart from the fact that, at 3.8% in February, core inflation is below RBI’s comfort zone of 4%, a host of other facts suggest a rate cut on Tuesday is a near certainty. Indeed, RBI Governor D Subbarao outlined several of them in a couple of speeches over the last fortnight. And the lesson to be drawn from the speeches is that, while RBI has to do its bit to help revive growth momentum in the economy, the government needs to continue to do its bit. On March 8, after he was at a joint press conference with the finance minister, Subbarao told the Bankers’ Club that, over the past few years, it was government affirmative action programmes and subsidies/welfare programmes that had contributed to the surge in rural wages and therefore was an important factor in the inflation spiral of the last few years. Add to this, the impact of increased procurement prices in India and the Chinese rebalancing—the latter meant a big global supplier of low-cost goods would be supplying less of these. Look at the spike in the fiscal deficit, from 2.5% of GDP in FY08 to 6% in FY09, and it is clear where the problem started.
We must recognise, Subbarao said on March 8, that the government doesn’t have the fiscal capacity to continue welfare spending at the old level, indicating his post-Budget comfort on the fiscal front. And on March 13, in his London School of Economics lecture, Subbarao defended rate cuts in the face of a rising current account deficit and also highlighted the differences in the pre- and post-crisis India: while higher investments in the pre-crisis period added to capacity and therefore kept inflation in check, higher government-spend in the post-crisis period coincided with a collapse in fresh investment and capacity creation, leading to a large demand-supply gap.
So, assuming RBI cuts rates on Tuesday, how will things pan out? For one, banks can’t cut rates unless there is some liquidity in the system—indeed, they are hiking deposit rates to attract deposits. Last year, liquidity was tight because RBI bought $20 billion worth of dollars to shore up the rupee; this time it is because the government is simply not spending money. So if it wants monetary transmission to be effective, the government has to either spend more or borrow less. Encouraging FII/FDI will also play the same role of creating liquidity. Given what Subbarao said about the lack of capacity creation adding to the inflationary impetus, clearly getting projects cleared through the Cabinet Committee on Investment (CCI) process has to be top priority for government through the rest of the year. Attention also needs to be paid to the unyielding CPI, especially the cereals part of it where, despite bulging stocks with FCI, the government has chosen not to dump stocks to lower the high inflation here. And since much of the RBI’s actions are predicated on the belief the government is serious about fiscal consolidation, the government’s commitment to a Food Security Bill continues to be worrying, more so given the level of provisioning the Budget has done for food subsidies. Which is why a 25 bps rate cut on Tuesday looks more likely than a 50 bps one.