Even less justification now for the high MSF rates
Given the steady improvement in US data, from GDP to employment, the Fed not starting its taper was a surprise, one possibility is Ben Bernanke may have thought it better to leave such a decision to his successor who, if it is Janet Yellen that gets the job, could be more dovish. Equally, when there is uncertainty over how the talks on the budget and the debt ceiling will work out between the Democrats and the Republicans, the Fed didn’t want to take a chance withdrawing stimulus by way of low interest rates. More important, as IMF’s last Article IV consultation pointed out, US needs to reduce its primary deficit by 0.9% of GDP every year till 2020—in other words, the recovery is by no means a done deal. While the Fed’s widely-awaited 2016 projections suggest the economy will be at full potential by 2016 when unemployment falls to 5.4-5.9%, what is surprising is that the FOMC’s suggested Fed funds rate at that time will be just around 2% which, in real terms, is near-zero. That suggests that while FOMC members have made their projections, they are not entirely convinced economic headwinds are going to ease in a hurry. One reason for this could be that each successive FOMC projection for GDP, going back several quarters, has had to be scaled back—in other words, getting growth back to full potential will take time. Interesting, in this context, is that while the FOMC has projected an unemployment rate of 6.4-6.8% in 2014, IMF’s projection is a higher 7.2%. Indeed, though employment has been rising, so has unemployment as more people are rejoining the work force.
For RBI, the Fed’s decision not to taper puts it in a bit of a quandary—since the taper will eventually take place, by January next year if not December this year, one school suggests RBI not cut rates for a few months till the US taper and its impact is factored in. The more immediate impact of the Fed’s decision, however, is to give RBI more room to ease policy rates, certainly to start dismantling the ‘interest-rate defence’ wall put up on July 15 which boosted interest rates 300bps immediately—the wall comprised not just the hike in MSF rates but also changes in CRR balances and LAF limits among others. Many argue lowering rates is bad idea since the rupee hasn’t quite stabilised and inflationary expectations also need anchoring. Since the Fed’s action means the dollar will weaken, the rupee gets an automatic stabilizer; also, to the extent interest rates in the US don’t rise too quickly, FII flows will be stronger. Equally important, the rupee’s pullback from approaching 69 to a dollar on August 28 to 61.8 on Thursday had little do to with the interest rate wall as it had to do with the Japan swap and the RBI subvention on NRI deposits—till the time RBI didn’t signal some climbdown, the rupee actually kept weakening. And with the economy weakening and more earnings downgrades, if FIIs are to remain engaged in equity markets—they have $145 billion invested in equity as compared to $11billion in debt—interest cuts are more meaningful. As for inflation, the recent spurt is driven by food which does not respond to interest rate hikes—core inflation in August is down to levels last seen in December 2009. Given the widening output gap, interest rate cuts also make sense given more productive capacity is put to use, lowering the possibility of inflationary surges. Any way you look at it, staying put like the Fed is not an option for RBI.