R Jagannathan
Firstpost.com
On 3 May, Reserve Bank of India (RBI) Governor Duvvuri Subbarao will be presenting his last annual monetary policy statement. The widespread expectation is that he will cut interest rates, since inflation seems to be coming down and growth needs a leg up.
In anticipation, the business press has already started beating the drums for a rate cut, and
Business Standard even talks of a buzz about the RBI delivering a pleasant surprise with a 50 basis points cut (100 basis points is 1 percent).
However, the case against any rate cut continues to remain strong, till the evidence that inflation is coming under control gets stronger.
Right now, inflation is falling on the wholesale side, but not the consumer side. While the Wholesale Prices Index (WPI) is down to 5.9 percent (it may still be corrected upwards to above 6 percent later), the Consumer Price Index for March is still in double-digits at 10.4 percent.
What this means is that the slowdown has reduced business’ pricing power, but consumption demand is holding prices up. The more immediate cause of the drop in WPI is declining global commodity prices – and the chances are that this decline could continue. But the domestic impact of this will be muted as long as the current diesel policy – of raising prices steadily every month – holds. Even today, the diesel price subsidy (or losses sustained by the oil companies) is Rs 6.42 a litre. It could take a year to neutralise this at the rate of 50 paise a month. In short, the fuel price uptick will continue all through till the next general elections in 2014.
The primary problem Subbarao faces is one of credibility. He fell flat on his face, not once but twice, by opting for easy money when it was unwarranted.
In 2010, he failed to raise interest rates on the presumption that growth needed a leg up rather than inflation a press down. At that time, the government’s post-Lehman stimulus packages were already beginning to create an inflationary spiral, boosting growth prematurely.
In 2012, based purely on
Pranab Mukherjee's promise that the fiscal deficit would be contained, Subbarao cut the repo rate (the rate at which banks borrow short-term funds from the RBI) by 50 basis points, when inflation was nowhere near trending down and fuel price increases were still to be passed on. (The current repo rate is 7.5 percent, and it has already been cut twice this year. Most analysts expect another 50-75 basis points cut in calender 2013.)
It is only now, after the fiscal correction has begun to take place under P Chidambaram, that WPI seems on the right trajectory. But this presents Subbarao with a different problem: is he following the right inflation index to really assume that inflation is headed south in a sustainable basis?
As Rajeev Malik, Senior Economist at CLSA in Singapore, points out, the RBI’s preference for watching WPI rather than CPI is “idiosyncratic” as it is in contrast to what other countries do.
Anywhere else, inflationary expectations are determined by consumers and not just industry. In India’s case, the new CPI is definitely the right index to target.
Says Malik: "It is a myth that CPI-new inflation is higher than WPI inflation only because of the higher weight of food. CPI-new core inflation is at 8.7 percent y-o-y versus 3.5 percent for WPI-core." (Core inflation is non-food, non-fuel inflation, and is a measure of underlying inflationary potential). “On balance, CPI-new is a better representation of inflation experienced by households. WPI inflation is highly sensitive to tradables and ignores several services which are likely to show higher inflation in light of rising incomes.”
Ridham Desai, Managing Director of Morgan Stanley India, also believes that cutting rates on 3 May would be premature. In an
interview to The Economic Times yesterday, he said that inflation data was not that conclusive as yet, especially in the context of the RBI’s earlier premature cuts. “I think the RBI is going to be slow at cutting rates because they had a bit of a bad experience in 2010 when they cut rates and inflation came right back at them. The good news for RBI is that fiscal consolidation is looking sustainable. But they’ll keep their eye on that and therefore on the CAD (current account deficit) and CPI.”
The International Monetary Fund has clearly
warned against presuming inflation is dying. “For countries where inflationary pressures have been elevated, vigilance on inflation will pay dividends for long-term growth,” the fund said. It issued a particular caveat on India: For example, in India, monetary policy can best support growth by putting inflation on a clear downward trend”.
Quite. And here are six reasons why Subbarao should hold his horses.
One, there is no case for a rate cut when CPI inflation is in double-digits.
Two, the fuel-price pass-throughs are far from being completed even in diesel, leave alone kerosese and cooking gas.
Three, in an election year, one has to budget for sharp increases in minimum support prices for foodgrain – which is what happened in 2008, starting off the medium-term inflationary surge.
Four, higher rates may be useful to draw in foreign capital inflows – which are critical for keeping the rupee stable. A stable rupee is vital for reining in inflation.
Five, rate cuts will not immediately improve investment, because few businessmen will invest when electoral outcomes and policies are so uncertain. Investment will not pick up till 2014, when the electoral outcome is clear.
Six, Subbarao cannot afford to have this written about his legacy: “He is the man who misread inflation signals twice – once in 2010 and again in 2012.”
His term ends in September 2013 and he has nothing to lose but his reputation.
The writer is editor-in-chief, digital and publishing, Network18 Group 
