Turn On the Taps in India
A familiar battle is shaping up in India. In the capital New Delhi, Finance Minister Arun Jaitley has declared that the country is ready for lower interest rates now that inflation looks to have been brought under control. In Mumbai, India's commercial capital, Reserve Bank of India Governor Raghuram Rajan disagrees. Just last month he made clear that he intended to keep rates high until inflation -- at 6.5 percent in September, the lowest since January 2012 -- comes down to a stable 6 percent.
Rajan has earned the confidence of financial markets during his stewardship of India's central bank. Defying conventional wisdom, he hiked rates twice upon taking office in September 2013 even as output was sliding, establishing beyond doubt his credentials as an inflation-slayer. Certainly, there's nothing new in a government pressuring the central bank to help goose a faltering economy. (Just ask Japan's Prime Minister Shinzo Abe.) The central bank governor is supposed to remain independent precisely so he can resist such entreaties.
Yet in this case, Jaitley is right: It's time for Rajan to slash rates. Even a cursory look at the data confirms that there is no excess demand in the Indian economy. The latest Index of Industrial Production for the month of August showed that industrial growth had fallen to a five-month low of just 0.5 percent. The index has revealed serious stress in the industrial sector since October 2013, when it turned in negative growth. That continued through the last months of the previous Congress-led government in February and March of this year. The index rebounded slightly as it became clearer that Narendra Modi would become India's new prime minister, registering a two-year high of 4.7 percent in May. But it has struggled to maintain any momentum since then.
For around 18 months, India has been caught in stagflation. The real cause of persistent inflation is on the supply side -- high prices of agricultural commodities and food, and until recently, soaring global commodity prices. Interest rates are not the best instrument to control such inflation. Supply side measures like increased food imports, or structural reforms which provide better incentives for farmers to raise output, are more appropriate.
Like the European Central Bank, the RBI hasn't always been very agile at tinkering with policy at the right time. In the summer of 2008, the central bank enacted a series of rate hikes in response to inflation driven by rising global commodity prices, particularly oil, rather than excess domestic demand. In September 2008, when the global economy crashed, inflation died out but the overhang of high interest rates damaged growth more than the situation warranted.
In 2010, by contrast, the bank was late in hiking rates to stem the inflation produced by the fiscal and monetary stimulus unleashed in the aftermath of the 2008 crisis. Rajan's early, determined hawkishness was useful for a period, but is now exacting an unnecessarily high cost. Like his predecessors, he may be behind the curve.
When fixing rates, the central bank governor must look at future projections and not just present data. The fact is, India desperately needs to restart its growth engine. A stifling interest rate regime is dampening investment and consumer spending.
In some ways, the circumstances could not be better for a cut in rates. Global commodity prices, particularly of oil, have cooled down. India's monsoon, a crucial determinant of food prices, turned out normal after an early scare. Modi's new government seems committed to fiscal prudence and is taking active policy decisions to boost investment. The looming Fed taper, which threatens to suck money out of emerging markets like India if rates drop too far, remains a safe distance away.
It isn't always healthy for an elected government and a central bank to be on the same page on policy. In this case, however, India needs them to be.
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