India's central bank urges government to stimulate growth

The Reserve Bank of India left the repo rate unchanged at 8% and the cash reserve ratio steady at 4.75% despite market predictions.

The RBI held the view that further reduction in the policy interest rate would only worsen inflationary pressures. Demand-supply imbalances need to be resolved. 

At this point, stimulating growth requires government policy efforts rather than looser monetary policy.  While another 50bps of rate cuts by Mar 2013 seems likely the timing is difficult to predict and will probably follow government reform efforts.

Here's more from DBS Daily Breakfast Spread:

The Reserve Bank of India yesterday shocked markets and left the repo rate unchanged at 8% and the cash reserve ratio unchanged at 4.75% amidst sharply slowing growth. Markets were almost unanimously expecting a 25bps policy rate cut though opinion differed on the need for a CRR cut. While the rate cut seems unjustified given the current deteriorating policy backdrop, the central bank and the government’s pro-growth stance, evident at the April policy meeting when rates were slashed by 50bps, meant further rate cuts are to be expected in June and July too.

The central bank has noted supply-side constraints to growth many times in the past, but it was especially explicit in its judgment yesterday as it noted “there are several factors responsible for the slowdown in investment activity, with the role of interest rates being relatively small” and that “further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures”. It added that the “widening current account deficit, despite the slowdown in growth, is symptomatic of demand-supply imbalances and a pointer to the urgent need to resolve the supply bottlenecks”.

This has been the view held for long and emphasized in a report ahead of the April policy meeting that rate cuts will have to follow, not precede, fiscal consolidation and growth-enhancing structural reform. The central bank does seem to have put the responsibility for stimulating investment and growth forcefully in the government’s court this time, but that its message has not always been consistent.

The RBI’s last rate hike was in late-October 2011. But it turned dovish not long after that in mid-December 2011, it cut the CRR by 50bps at the late-January policy meeting and noted that “the growth-inflation balance of the monetary policy stance has now shifted to growth” and it will “respond to increasing downside risks to growth”.

After lowering the CRR by 75bps in early March, the RBI struck a more neutral tone at the mid-March policy meeting and noted “upside risks to inflation have increased”. It, therefore, came as a surprise when just a month later in April, the RBI noted that growth is sub-potential and that its endeavor is to “adjust policy rates to levels consistent with the current growth moderation”.

It cut rates by 50bps in a single step at the April meeting, effectively easing monetary policy in anticipation and ahead of government steps towards fiscal consolidation. In the June statement, the RBI’s language and tone has turned neutral once more as it has cautiously judged that “further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures”.

A central bank’s job is never easy and the RBI is in especially a difficult position given its focus on multiple objectives on growth, inflation, stability etc. It has bore more than its share of burden in controlling inflation in 2010-11, while fiscal policy has remained accommodative. Now, it faces pressure to reduce interest rates to stimulate growth, even as stimulating growth at this juncture requires government policy efforts rather than looser monetary policy. To make matters worse, the growth-inflation mix has been challenging, with growth surprising to the downside and inflation surprising to the upside. Yet, the inconsistent policy message makes forecasting interest rates difficult.

Rate cuts in the near-term seem unlikely given inflation is not expected to come off in the near-term. Having expressed in very clear terms that the room for monetary policy stimulus is limited, it is unlikely that interest rates are tinkered with until concrete policy steps from the government that address the supply-side bottlenecks constraining growth.

This will require steps to boost infrastructure spending, improve the business climate and reduce subsidies. It will also require prioritizing agriculture sector productivity, notably by liberalizing retail FDI and making fiscal space for public investment in agriculture. It is critical, too, that efforts to rein in the fiscal deficit do not result in greater business costs and policy uncertainty, as has been the case since early this year.

2012/13 is expected to be a challenging year. Reducing deficit will be difficult in the backdrop of a weakening rupee and heightened global growth uncertainties. The rupee is only about 4% weaker on a trade-weighted exchange rate basis compared to average 2009-11 levels. This suggests the adjustment in the currency is far from complete.

Further rupee weakness will limit gains from falling international oil prices. Falling oil prices also won’t help narrow the twin deficits if it is driven by worries of global growth. In this backdrop, the outlook is pessimistic than consensus and expect growth in 2012/13 to slow to 6.2% from 6.5% in 2011/12. It seems another 50bps of rate cuts by Mar 2013 is in order, but the timing is difficult to pinpoint and is expected to follow government reform efforts, rather than precede it.