The Real Meaning of India's Rate Cut
India's hawkish central banker Raghuram Rajan certainly cheered investors with his second surprise rate cut in less than two months: The country's benchmark stock index temporarily zoomed to a record after Rajan lowered the repurchase rate -- the rate at which commercial banks borrow from the Reserve Bank of India -- by 25 basis points to 7.5 percent.
The move should boost investment and consumer sentiment in a country that remains burdened by high interest rates relative to the rest of the world. It should add to any growth momentum generated by Prime Minister Narendra Modi's first full-year budget, which was released to mixed reviews on Feb. 28. Most importantly, it could help India defy the conventional wisdom that the economy can't record high growth until it undergoes big-bang liberalizing reforms.
India does confront several major structural problems that hamper the economy -- in land, labor and capital markets -- most of which emerge from the excessive and misplaced intervention of its leviathan state. None of those problems, however, preclude a sound macroeconomic environment characterized by low and stable inflation, which is critical to investor and consumer confidence. Between 2010 and 2014, when GDP growth rates cratered, rampant inflation damaged India's prospects as much if not more than a lack of policy reform. That's why Rajan has made reining in inflation his top priority.
Why has he softened his stance now? The statistics on inflation have been encouraging for some months; he could well have cut rates earlier. Consumer price inflation stood at 4.38 percent in November 2014, down from over 8.5 percent in April 2014. Wholesale price inflation for the same month was zero. The latest statistics for the month of January actually show an increase in inflation to 5.11 percent, which might argue for a status quo on rates.
Three factors could explain Rajan’s decision -- all of which involve less-than-flashy measures announced by the government this week. First, Rajan appears convinced that Modi's administration is serious about improving India's fiscal position. The central bank governor would always have been reluctant to ease monetary policy as long as fiscal policy was too loose and fueling inflation on its own. Ironically, in the budget, the government actually delayed its fiscal consolidation targets for a year. But the extra spending was committed to productive public investment -- mostly in infrastructure -- rather than any new populist spending measures. (The government has also begun phasing out wasteful fuel subsidies, and resisted dramatically hiking price supports for certain key agricultural goods -- a traditional driver of inflationary expectations.) That's added unusual credibility to the government's numbers, which seem to balance fiscal austerity with the cause of growth.
Second, for the first time, the government and the RBI have signed a formal agreement on a new monetary policy framework. Under this arrangement, the Finance Ministry has given the central bank an explicit inflation target of 4 percent, plus or minus 2 percent. Any deviation from this target would require an explanation from the RBI governor. This should bring much-needed stability to the macroeconomic environment. Until now, the central bank had no clear indication of what its priority should be. In fact, it wasn’t even clear if the main goal of monetary policy was to contain inflation, promote growth or manage the currency. The RBI had earlier set itself a target of 6 percent for January 2016; the current inflation rate is already below that and within the new target range set by the government. Unsurprisingly, Rajan responded by cutting rates.
Third, the government has laid out plans for a radical reform of the RBI. The bank has been stripped of its responsibility for managing the government's debt -- which posed a conflict of interest given its task of setting rates. More importantly, interest rates will henceforth no longer be decided by the governor alone but by a monetary policy committee. (The changes will require legislation later this year.) Both reforms would bring India’s central banking practices closer to globally accepted standards. Presumably, that gave Rajan greater confidence in the government's commitment to establishing a sound macroeconomic environment.
Modi's budget may not have been radical enough for some critics, focusing more on incremental reforms rather than the kind of sweeping changes many free-market proponents wished to see. But bringing the Finance Ministry and the RBI onto the same page is a major accomplishment in itself. "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. That in itself should be a boost to growth, no less than the mood of India's giddy punters.
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