Urjit Patel report forces RBI to keep rates high
Had RBI not brought in the Urjit Patel committee report with its CPI-based inflation targeting approach, there is little doubt interest rates would have been cut by now. At 3.46%, WPI inflation is at a 5-year low and, even if you go by the CPI which is now in vogue, core inflation hasn’t been lower since January 2012—so it’s not just the food prices we’re talking about. The reasons for the slowing in inflation are equally obvious. While economic growth continues to remain anaemic for the third year in a row—that’s why, with no takers for loans, SBI has just cut its deposit rates, and other banks will follow—the game changers as far as inflation is concerned is the dampening of the MSP-rate hikes and the government finally deciding to start offloading FCI’s huge stock of grain. Along with an overall softening of global commodity prices—partly the result of the US cutting back on liquidity which was flowing into, among others, commodity markets—this has resulted in CPI cereals inflation falling to 7.4% in August 2014 versus an average of 14.9% in 2013 and 8.9% in the first 8 months of 2014; CPI fuel and light has fallen to 4.15% in August versus 7.9% in 2013 and 5.4% in 2014. It also helps that, as the Budget reinforced, the days of unbridled government spending, especially in rural areas, are also over for now.
Given this, it is difficult to see why RBI Governor Raghuram Rajan is so hawkish on inflation—a few days ago, he said rates could not be cut till there was more evidence on inflation slowing. While the likelihood of US interest rates rising raises fears that FII debt flows—at $18.7 billion till September, these are the highest in a decade—could start flowing out, more so if the rupee collapses, this has to be juxtaposed against higher FII equity flows as well as increased FDI prospects. At $14.1 billion till September, FII equity is likely to be the second- or third-highest in the last decade. And if even a fraction of the promised Japanese/Chinese promised investment comes in, this is a significant addition to FDI flows which averaged $28 billion per year over the last five years.
Though it doesn’t look likely there will be a huge exodus, it makes sense for RBI to pause and wait to see how the US interest rate scenario unfolds—the excess European liquidity, of course, could push more money into emerging markets. The larger point, however, which the finance minister needs to examine urgently, is the issue of the CPI-based inflation targeting model which will lock RBI into a higher interest rate scenario for a longer period than what India’s fragile macro demands. As this newspaper has pointed out before, apart from the fact that a single-minded inflation-targeting model doesn’t work, several of the report’s assumptions are simply incorrect. To cite one, if high inflation was the reason for the decline in financial savings as the report posits, why did the opposite happen in previous periods of high CPI inflation such as FY10? Also, with the government moving to address supply constraints by clearing stuck projects—apart from the demand-side measures talked about—this is another big reason for inflation slowing.