With the trough still ahead, RBI must act

By Sherman Chan

MUMBAI: The Reserve Bank of India will likely resume monetary easing at its upcoming quarterly meeting. In recent months, the central bank has appeared hesitant to cut interest rates, despite downbeat economic prospects. India's weak fiscal position, coupled with still-high consumer price inflation, may have made the RBI cautious about exercising monetary policy, often perceived as the only weapon left with which to fight the economic downturn.

Wholesale price inflation came in at only 0.18% year-on-year for the week ended April 4 and is set to dip into negative territory in coming weeks. Yet the pace of consumer price growth is still high, with the CPI rising near double-digit rates. The wholesale index is watched more closely because it is timely, but the CPI is no less important, as it directly relates to household budgets.

Nevertheless, the movement of the CPI is largely determined by the government because of its control over food prices. Policies such as agricultural price guarantees for certain farm products have elevated prices and also kept food costs firm even as global prices have cooled. To assist the agricultural sector, which supports about two-thirds of the Indian population, the government should focus on fundamental reforms rather than using price distortions.

Meanwhile, the RBI should not let inflation worries discourage it from loosening monetary policy. All fiscal stimulus packages require the support of strong lending. Yet credit growth in India has slowed in recent weeks, and the RBI is now under more pressure to cut both the repo and reverse repo rates. Commercial banks have been slow in passing on the previous policy rate cuts to customers, with many citing a still-high cost of funds due to reasons such as term deposits. To allow more room for commercial banks to lower rates, the RBI is urged to trim the repo rate.

On the other hand, the reverse repo rate also needs to come down to discourage commercial banks from placing funds at the RBI rather than extending credit to firms facing a liquidity squeeze. There is also rising speculation that the central bank may soon have to impose a ceiling on funds parked by commercial banks if the squeeze in lending and bond markets worsens.

Governments of some economies have claimed that a bottom is in sight, and recent data from China suggest the dragon economy may have already hit its trough in the current cycle. However, the worst for India is yet to come, as signs of weakness are still growing. Hence, the RBI needs to ensure ample liquidity in the market and facilitate credit growth to help support the economy. Moody's Economy.com forecasts the repo and reverse repo rates will be cut by 50 basis points to 4.5% and 3%, respectively, this week.

(The author is an economist at Moody's Economy.com)