Arun Jaitley’s smile, the rate cut, and a few questions


On Saturday, at the post budget press conference, the first question that India’s finance minister Arun Jaitley faced was: “Now that you have pushed the fiscal deficit target of 3% to 2017-18, justifying increase in capital spend, do you think that the big elephant in the room—the Reserve Bank of India—is going to support your idea of enhancing growth by cutting rates anytime soon now?”

Jaitley replied with a meaningful smile: “I think you need to have a little patience to get the answer to your question.”

We have got the answer three days later, but the question is: Why didn’t RBI cut the rate on Monday or even Tuesday, if not on Saturday immediately after the presentation of the budget (such a thing had happened in the past)? Why did it have to wait till Wednesday?

(Incidentally, addressing the students of Guru Nanak College in central Mumbai on Monday, RBI governor Raghuram Rajan had said, “Our problem is: we also have high inflation, we cannot cut interest rates very quickly to the bone…”)

So, what happened between Saturday—the day of the Budget presentation—and now that has prompted Rajan to cut the rate? Any flow of fresh data?

Four things have happened.

– China’s central bank cut interest rates for the second time in less than four months. The cut, effective Sunday, lowers by a quarter percentage point both the benchmark one-year loan rate, to 5.35%, and the one-year deposit rate, to 2.5%. The People’s Bank of China singled out rising deflationary pressure as a trigger for the move.

– Factory activity in India expanded at its slowest pace in five months in February as a slowdown in new orders dragged on overall output, HSBC Manufacturing Purchasing Managers’ Index (PMI) survey showed on Monday. The index fell for the second consecutive month, to 51.2 in February from 52.9 in January.

– The growth in eight core industries slowed to 1.8% in January, the lowest in 13 months. Negative growth in crude oil and natural gas and low growth in steel, cement and electricity have led to the dip in the overall growth rate of core industries.

– Finally, the agreement between RBI and the finance ministry on monetary policy framework has been placed in the public domain.

However, none of them, including the agreement (it was signed on 20 February), could be the reason for the rate cut on Wednesday. It is a predetermined cut. Rajan could have cited the same reasons for the cut had he announced it immediately after the budget. This is also makes it clear that there is no conflict between the finance ministry and RBI as far as the trajectory of interest rates is concerned. Jaitley’s smile at the post-Budget conference said it all.

Does this inter-meeting action—second since January—signify more space for rate cuts? I have my doubts. Rajan has possibly advanced the April action to March to complement Jaitley’s budget and may not do anything in April. After cutting the rate in January, he didn’t do anything in his February policy, saying nothing had changed. He will probably take a similar stance in April.

In fact, the text of the RBI release said, “given low capacity utilization and still-weak indicators of production and credit off-take, it is appropriate for RBI to be pre-emptive in its policy action to utilize available space for monetary accommodation.” In other words, he has frontloaded the cut.

After the latest cut, the policy rate is now 7.5%. To what extent will it go down by the end of the year? Inflation is likely to be 5-5.25% in the first half of the current year, inching towards 5.5% in the second half, and the average inflation for the year could be in the range of 5.25% to 5.5%.

Since Rajan wants a 1.5-2% real interest rate, one can reasonably expect one more rate cut of a quarter percentage point and, at best, another by as much this year, taking the policy rate to 7.25-7%. Only a dramatic collapse of inflation can lead to a sharper cut.

Finally, one should take a note of the change in Rajan’s guidance for the year till December. While announcing the rate cut in January, he had said, “the key to further easing are data that confirm continuing disinflationary pressures. Also critical would be sustained high quality fiscal consolidation”.

This time around, he has gone beyond inflation and fiscal consolidation and cited a host of elements as a pre-condition for a rate cut. They include easing of supply constraints, improved availability of key inputs such as power, land, minerals and infrastructure, the monsoon out-turn and international developments besides continuing progress on high-quality fiscal consolidation and banks lowering their loan rates. He has raised the bar. Wednesday’s rate cut is unlikely to open the floodgate for future rate cuts.

PS: In my column on Monday, I wrote that RBI will not be in a hurry to cut rates. I eat humble pie. But I bet had I watched Jaitley’s smile in the post-budget press conference on the rate cut question, I would not have written that! I watched it this morning on Youtube after a bond dealer told me about this.

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