Sharper-than-expected cut in policy rates not justified by macro-realities

The Reserve Bank of India’s (RBI) shock therapy is a gamble, unwarranted by ground macroeconomic realities and, ironically enough, by the Bank’s own policy pronouncements!

If the 50-basis-point reduction in the repo rate took markets by surprise, it was only because it goes completely against the grain of central banking: to err on the side of caution.

Especially when the choice is between the distinct probability of reigniting lurking inflation and the faint possibility of kickstarting growth in a scenario where government failure, rather than high interest rates, is the drag on investment.

The Bank admits as much, saying “inflation remains sticky and above the tolerance level”. Also that the “deviation of growth from its trend is modest while upside risks to inflation persist”. These considerations, it adds, inherently limit the space for further reduction in policy rates.

Correction, Governor! These factors — abundant global liquidity, sharp increase in private final consumption, rising oil prices without a corresponding passthrough to domestic prices, high current account deficit and government’s fiscal profligacy — had already limited the space for reduction in policy rates.

In the circumstances, one could, at best, have argued for a nominal 25-basis-point reduction in policy rates on the grounds that it might be worth a small gamble, given that growth has slowed down more than anticipated. What we have, instead, is a larger-than-warranted reduction.

The stance of monetary policy, says the Bank, “is intended to adjust policy rates to levels consistent with the current growth moderation, guard against risks of demandled inflationary pressures re-emerging and provide more liquidity”.

Well said! Except that the action that follows is not consistent with the objectives. The hope, quite clearly, is that an aggressive rate cut will stabilise growth (around its post-crisis lower trend growth, estimated at 7.3% for the current year) and contain risks of inflation and inflation expectations surging again.

Is that wishful thinking; a triumph of hope over experience? The silver lining is that the rate cut makes it all the more imperative that the Centre contain its deficit, to rein in inflation.