Rajan Cuts India Rates After Modi Agrees to Inflation Target

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RBI Governor Raghuram Rajan
Raghuram Rajan, governor of the Reserve Bank of India, cut the benchmark repurchase rate to 7.5 percent from 7.75 percent, the central bank said in a statement on Wednesday. Photographer: Dhiraj Singh/Bloomberg

Reserve Bank of India Governor Raghuram Rajan cut interest rates in an unscheduled move days after the government agreed for the first time to give the central bank a legal mandate to target inflation.

Rajan, citing weakness in Asia’s third-largest economy, lowered the benchmark repurchase rate by a quarter percentage point to 7.5 percent, the second such move this year. Economists at banks including Goldman Sachs Group Inc. had anticipated the RBI to hold off until the next meeting, on April 7.

India’s move is the latest salvo in an onslaught of global easing outside the U.S., with more than a dozen central banks adding stimulus so far this year. The central bank alluded to the need to keep up with counterparts in the easing cycle, saying the rupee remained strong relative to peers.

The decision also followed quickly on Prime Minister Narendra Modi’s agreement to a yearlong quest by Rajan to boost the central bank’s independence and focus on price stability in the nation with one of Asia’s fastest inflation rates. The agreement calls for an inflation target of four percent, with a band of plus or minus two percentage points.

“This makes explicit what was implicit before -- that the government and the Reserve Bank have common objectives and that fiscal and monetary policy will work in a complementary way,” Rajan said in today’s RBI statement, referring to the monetary policy framework agreement unveiled on Monday.

The rupee declined 0.6 percent in Mumbai on Wednesday, the biggest drop in more than three weeks, and the yield on the 10-year sovereign bond fell to 7.69 percent from 7.75 percent. India’s benchmark stock index, which climbed to a record soon after the rate cut, dropped 0.7 percent.

‘Quite Surprised’

Twelve of 15 economists surveyed by Bloomberg News after the budget predicted Rajan would reduce the repurchase rate only at the next scheduled review. Three saw the chance of a cut this month even after Modi postponed by a year a plan to narrow the fiscal deficit to 3 percent of gross domestic product.

“The only rational explanation is that they wanted to immediately reward the government for signing the monetary policy framework document,” said Dariusz Kowalczyk, an economist with Credit Agricole CIB in Hong Kong who covers India. “I’m quite surprised by the fact they cut rates right after the budget -- I thought the wider budget deficit would discourage them.”

Interest-rate swaps show that investors are betting that India will cut the benchmark rate by another 50 basis points by the end of 2015, the steepest decrease after Turkey among 14 emerging markets tracked by HSBC Holdings Plc.

Easing Inflation

“It’s quite clear that India is an outlier in terms of high interest rates relative to the world,” Jayant Sinha, deputy finance minister, told reporters in New Delhi after the decision. “We have a set of circumstances that will guide you to believe that there will be an easing on the monetary side.”

Finance Minister Arun Jaitley on Saturday said he’d streamline and simplify the process of granting project approvals and lower the corporate tax rate. He reiterated he intends to implement a goods and services tax in April 2016 that’ll turn India into a single market for the first time and boost Modi’s signature campaign to boost local manufacturing.

“I have no doubt in my mind that the various medium term measures proposed in this budget will certainly help the country become a powerhouse in the world,” Rajan said in a conference call on Wednesday.

Rajan left rates unchanged last month after an unscheduled reduction in January. Consumer prices rose 5.11 percent in January, third fastest among 17 Asian economies tracked by Bloomberg, though below his 6 percent target for January 2016.

Strong Rupee

Rajan said today that inflation would stay “below” 6 percent in the second half of 2015, with risks including a rebound in oil prices, volatility from international financial markets and higher food costs due to a weak monsoon. The central bank will seek to bring inflation “to the mid-point” of the target inflation target by April 2018.

While saying “an excessively strong rupee is undesirable,” Rajan also noted that it helps disinflation. The central bank doesn’t target a level for the exchange rate or foreign exchange reserves and intervenes on occasion only to reduce volatility, he said.

“Further monetary actions will be conditioned by incoming data, especially on the easing of supply constraints, improved availability of key inputs such as power, land, minerals and infrastructure, continuing progress on high-quality fiscal consolidation, the pass through of past rate cuts into lending rates, the monsoon outturn and developments in the international environment,” Rajan said.

Pre-emptive Move

Before the budget, Rajan said he’d look for spending to shift toward supply-enhancing infrastructure. While the postponement of fiscal consolidation is “a source for concern,” the shift in funds to states and infrastructure projects helps mitigate the risks, Rajan said on Wednesday.

“The fiscal consolidation program, while delayed, may compensate in quality, especially if state governments are cooperative,” Rajan said in the statement. “Given low capacity utilization and still-weak indicators of production and credit off-take, it is appropriate for the Reserve Bank to be pre-emptive in its policy action to utilize available space for monetary accommodation.”

Jaitley said on Saturday that spending for roads, ports and bridges would rise 25 percent, largely funded by sale of stakes in state-run companies and market loans while food and fertilizer subsidies are slated to rise. He also said the government would amend the central bank law to form a monetary policy committee.

‘Same Page’

“This shows that government and RBI are on the same page in their assessment and outlook of the economy,” Arvind Subramanian, the finance ministry’s chief economic adviser, said by phone after the decision. “This is also a sign that the budget is conducive to non-inflationary and durable growth.”

The inflation target, informally adopted by Rajan after he became governor in September 2013, is the biggest revamp of the central bank’s mandate in its 79-year history. It reduces the risk that future policy makers will abandon the overhaul in a nation dependent on oil imports where 59 percent of 1.2 billion people live on less than $2 per day.

Rajan said the agreement, along with signs of economic weakness, spurred him to move in between policy meetings. He said the economy was “steadily recovering” even while forecast to grow as much as 8.5 percent in the coming fiscal year, the fastest pace among major emerging markets.

“This could lead to a front-loading of cuts that could include another 25 basis points in April,” said Rupa Rege-Nitsure, an economist with L&T Finance Ltd. in Mumbai. “After that, I’d expect a hold with any further action being largely data dependent, with particular emphasis on the direction of oil and inflation.”

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