The RBI is in no hurry to cut interest rates despite inflation trending low for several months now and there being no obvious immediate reason why it should move up sharply.
Raghuram Rajan, the RBI governor, may have good reasons to be cautious though, considering what happened during the previous governor D. Subbarao’s tenure. He took charge as the governor in September 2008 and stayed on for 5 years.
His tenure’s start coincided with the global financial crisis. The governor and the government joined hands with a monetary and fiscal stimulus to protect India’s economy and financial markets. Global financial markets were also awash with funds due to quantitative easing. It worked. GDP growth did fall sharply in FY09 but recovered subsequently.
Now, this should have been the time the government and the RBI unwinded the stimulus. Unlike the US, we did not go into a prolonged slowdown.
But just look at how inflation did, declining all the way till August 2009 but after that, it went up and briefly looked like it was declining in end-2011. But that did period did not last long. Meanwhile, the RBI’s repo rate did respond to shifts in inflation but almost always got caught napping when it reared its head again.
The impact on retail inflation was even more pronounced, hitting double digits on several occasions and saying above 8% for over two years since 2012.
Looking at inflation and interest rates together in the same chart illustrates the point better, though the chart does look a little crowded. It shows the few occasions that inflation softened, and the RBI followed suit, only to see inflation surge up soon after. In some cases, a high base effect gave an illusory effect of declining inflation.
Waiting longer, Mr. Rajan has decided, is definitely a better option. After December, the high base effect wears off and the more normal rate of inflation will present itself. The government’s budget exercise will also throw light on the state of the fiscal deficit and the government’s spending plans for FY16. These are all important inputs in the RBI’s decision making process to press the rate reset button.