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Disinflationary tactics

16 December 2011 By Jeff Glekin

It’s not intuitive, but cutting rates may be India’s best bet in fighting inflation. The central bank can’t really raise rates, the normal cure for rising prices, because the economy is weak. Flat rates, meanwhile, will achieve little. In the circumstances, cutting rates might be an unconventional way to perk up the market and halt the pressure on the rupee.

Equity markets dropped to a two-year low as the Reserve Bank of India called an end to its latest interest-hike cycle. No wonder: core inflation remains stubbornly high. Although food inflation has finally dropped, the wholesale price index remains above 9 percent. After 13 rate hikes in the past year and a half, demand has begun to moderate, but high financing costs have also dealt a beating to the supply side. Spending on capital goods fell 25 percent, year on year, in October.

Then there’s the rupee. It’s down almost 18 percent since July, which is driving up the cost of imports and making inflation worse. In normal times, a cheap currency might help kickstart manufacturing companies by increasing demand for exports – but right now, external demand is hardly booming, so that natural curative effect isn’t working. India can hardly compensate by buying less from abroad, since imports are geared towards essentials like fuel.

Here’s how a rate cut could help. First, it would get business moving again. That would in turn raise share prices and reassure investors, restoring confidence that is currently lacking.

Secondly, it could help revive the rupee. True, investors traditionally chase currencies in countries with higher interest rates. But the rupee is driven more by investors’ views of India’s economy – and it is because they stopped investing that the currency fell. With industry revived, investors should return and the rupee may strengthen, which would make imports once again more affordable, and reduce one source of inflation.

All this is easier said than done. The government in Delhi has a credibility problem with investors, especially after its failed efforts to open up the retail sector to more foreign capital. The RBI could face a credibility problem of its own, if the experiment doesn’t pay off. But when all options look unpalatable, some unconventional thinking is surely worth a punt.

 

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