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Course correction

15 January 2015 By Andy Mukherjee

Raghuram Rajan’s first rate cut is just one of the several that investors will expect from India’s central bank governor this year.

The quarter-percentage-point decrease won’t revive a sluggish economy overnight. But the unscheduled decision announced on Jan. 15 is not a one-off. As Rajan said in his statement, he now has the “headroom for a shift in the monetary policy stance.”

Falling energy prices are a big help. The Reserve Bank of India’s target of 6 percent inflation by January 2016 is already in the bag, and unlikely to slip out again. What’s skidding, though, is growth: industrial production is stagnant. Keeping the policy rate at 8 percent would have been ill-advised.

It would also have achieved little. Rajan has already re-established the RBI’s credibility as an inflation hawk. Consumer prices rose just 5 percent in December, a far cry from the double-digit inflation the former International Monetary Fund chief economist inherited when he took up the job in September 2013.

Back then, investors were punishing India for its high inflation, wayward government spending, and wide current-account deficit. Rajan raised the policy rate and squeezed domestic demand to wring out inflation. He also gave a clear message to the new government in New Delhi that monetary rewards would depend on stricter budgetary discipline.

All those goals have been met. The government is keeping a tight lid on public expenditure, and has broken away from the past practice of paying farmers overly generous prices for staples. Rural wage growth – a big driver of inflation in India – has turned sharply lower.

Finally, the risks to India’s financial stability from lowering rates are currently low. Long-term interest rates in advanced nations are falling. A repeat of the mid-2013 “taper tantrum”, when the country saw large capital outflows, is unlikely even if short-term U.S. rates rise later this year.

If anything, lower borrowing costs will allow Indian companies to revive some of the large infrastructure projects they have abandoned. That would also help the banking system.

Rajan has put the ball in the government’s court. Investors will now want to see a strong reform push in the upcoming federal budget, followed by more rewards from the central bank – in the form of more rate cuts. 



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