It can be no one’s case that interest rates alone are responsible for keeping the economy down—April to August IIP is at 0.4% compared to 5.6% in the same period last year and capital goods fell 13.8% in April-August as compared to a growth of 7.3% in the same period last year. It’s obvious that for large infrastructure projects, the slowdown in which is really at the heart of the current slowdown, coal linkages are far more important than a 25-50 bps cut in the repo rate. And with WPI inflation rising, at 7.8% in September, there are the usual cries for RBI to not cut interest rates—any cut in rates, the argument goes, will fuel overall demand and thereby undermine monetary policy efforts so far. There are several reasons for RBI to act, apart from the obvious one that if raising repo rates from 4.75% in March 2010 to 8.5% in October 2011 didn’t help curb inflation and the cut in repo in April didn’t fuel inflation, they are unlikely to do so now. The most obvious reason for this is the sharp slowing in overall demand, as witnessed by quarterly consumption data as well as India Inc’s top line growth—look at the near collapse in two-wheelers and commercial vehicles as a pointer. If inflation has remained stubborn despite this, it is largely driven by primary commodities where monetary policy has little role to play. To the extent contribution of manufacturing inflation remains at around 50%, the fact that IMF projects a 2.9% fall in commodity prices in 2013—a 1% fall in oil prices—suggests this may be a temporary phenomenon. Interestingly, RBI’s macro review yesterday points to gold and ornaments being a big contributor to core inflation—it concludes: “While accessing ... price pressures ... such disproportionate influences need to be taken into account.”
The biggest reason for RBI to act is the strong correlation between lagged core inflation and the value of the rupee—given this, a policy that helps shore up the rupee will help in curbing inflation. Obviously concerted government action to clear projects (think National Investment Bureau) is critical, but an interest rate cut makes projects viable at the margin—and we’re talking of a 250 basis points hike in SBI base rates, or a 33% hike in 18 months. Apart from that, rate cuts make equity a better option—a recent Goldman Sachs report shows how, with a lag, rate cuts lead to significant re-rating of infra stocks—attract more flows and make the rupee stronger. It is possible to dismiss as coincidence the strong correlation between rising interest rates and stalled projects, but how do you explain real interest rates being the highest they have been in years—they were at around the same level in the go-go days of 2008, but in those days GDP had a lot of growth potential built into it, unlike today.
Lastly, when RBI was talking of the need for fiscal policy to do its bit, it meant a start; it didn’t mean a complete elimination of the fiscal deficit. Well, that’s happening. Indeed, for the first time in many years, fiscal policy is setting the stage for RBI to take action—that’s why the finance minister told the nation yesterday that this year’s fiscal deficit would be 5.3% of GDP and not the 6.1% that most expect.