With wholesale inflation falling to a three-year-low of 7.18 per cent in December, the stage is set for the Reserve Bank of India (RBI) to start cutting interest rates in its next monetary policy review on January 29. This has become unavoidable, more so when yields on the benchmark 10-year Government paper have dropped to 7.8 per cent, the lowest since August 2010 and also below RBI’s ‘repo’ or lending rate of 8 per cent. What it means is that the Government today is able to borrow 10-year money from banks at a cheaper rate than what the latter are paying for overnight one-day funds from RBI. The fact that 10-year bond yields are lower by almost a full percentage point compared to April — and we are now supposed to be in the ‘busy season’ for credit — shows businesses aren’t really borrowing, which, in turn, is indicative of slack economic activity. Banks’ non-food credit growth for April-December, at Rs 389,110 crore, is down in absolute terms, against the increase of Rs 404,530 crore for the same period of 2011.
Inflation hawks will, of course, argue against any rate cutting even at this point. One reason they would certainly cite is consumer price inflation, which has actually risen to 10.56 per cent for December, from the preceding month’s 9.9 per cent. In other words, price increase at the retail, as opposed to wholesale, end remains at elevated double-digit levels. Secondly, since the Government plans to hike prices of diesel, LPG and urea prices soon, the resulting ‘pass-through’ is bound to raise wholesale inflation all over again. Both these arguments, though, miss the central point about the effectiveness of monetary policy. There is little it can do to control price increases in wheat, vegetables and other foodstuffs, which have bigger weightage in the consumer price index and are, indeed, driving it up now. High interest rates are more effective in addressing non-food manufacturing or ‘core’ inflation, a more accurate measure of demand-side pressure on prices. This has dipped sharply from 5.7 to 4.2 per cent between September and December, reflecting the success of monetary policy in containing such pressures.
That said, maintaining the above stance at this juncture would only further hurt growth and investment. By bottling up supplies, it will not help RBI’s own commitment to low and stable inflation in the medium term. While declining capital goods production for the last many months is a clear signal of low investment activity, there are enough indicators now – from car sales heading for negative growth this fiscal for the first time since 2002-03 to domestic airlines offering steep fare discounts – pointing to slowing consumer demand as well. On January 29, RBI should act on its mid-quarter review statement last month that monetary policy must “increasingly shift focus and respond to the threats to growth from this point onwards”.