India needs to cut policy rates, not raise them
Given how RBI Governor Raghuram Rajan is already so hawkish, the last thing he needs is for someone to argue, not just against lowering rates, but for hiking them. Yet that’s just what the IMF has gone and done. In its ‘global prospects and policy challenges’ at the G20 summit in Cairns, Australia, the IMF has said: “In India, more efforts are needed to continue reducing stubbornly high inflation and the large fiscal deficit … sustainably lowering inflation will also require further increases in the policy rate …”. The fact, however, is that inflation in India has not just been falling, it has fallen in a very big way. At 3.46%, WPI is at around a 5-year low and core CPI inflation—if you remove the seasonal vegetable and fruit inflation—hasn’t been lower since January 2012. And with the government now showing commitment towards reform of agriculture markets and finally beginning to release stocks from its bursting granaries, cereals CPI is down to a two-year low and is all set to slow even further. While many would contest the high deficit leads to high inflation argument since a lot depends on how things look on the supply side, the fact is that the fiscal deficit is also reined in. Indeed, ever since the government has affirmed its commitment to using Aadhaar for cash-based subsidy transfers, subsidy reforms are now a given.
What it all boils down to, of course, is what causes inflation and whether interest rate cuts will drive economic growth, particularly investments. Economists have different models, and different things matter to different economists at different points in time, but most would agree the exceptionally high hikes in minimum support prices during the last government’s tenure, coupled with the high welfare spending in rural areas, is what put in place the vicious inflation spiral we’ve seen over the last few years. With the growth in minimum support prices now in check and ditto for rural spending, the impact of this has already been partially seen, and will be seen in the months ahead. And it helps that, with global commodity prices—including fuel—being what they are, this will put further downward pressure on inflation. If this is not the opportune time to cut rates, it is difficult to see when else this could be.
The question that arises is whether cuts in interest rates will stimulate investment spending, more so at a time when capacity utilisation levels are just around 75%. This is a bit tricky since investments are not going to start unless investors are convinced policy action—such as on releasing more telecom spectrum, for instance—is going to be friendly. So there is likely to be a bit of a sequencing issue. But in a low-growth scenario, and India is in that for at least a few more years, it is difficult to see how investments are going to be viable at current rates of interest.