The Hindu Business Line : Cues from the Fed

Barely a fortnight ago the RBI Governor, Dr Y.V. Reddy, made public a concern that policymakers should have aired two months ago when it became clear that the US sub-prime crisis was not just a case of financial judgments gone awry. At that time analysts all over the world were already concerned that the credit squeeze was not restricted to inter-bank lending and was likely to spread to the credit market itself. Most policymakers preferred to believe that the crisis would blow over and that the US economy was not headed for recession; till the RBI governor voiced his anxiety to presspersons in Mumbai recently.

Mr Reddy’s comments that global uncertainties “were not entirely unanticipated” “but the intensity was not predicted” may anticipate some more details on Tuesday when the Reserve Bank of India’s quarterly review of the economy is released. Most likely, the uncertainties will influence the central bank’s policy toward financial stability in the domestic system even more so now than in late 2006. At the time, the RBI had perceived External Commercial Borrowings and surging capital inflows as the main threats to financial and price stability. Now, the threats are exogenous — turmoil in financial markets, and fears of economic slowdown alongside world inflation led by rising oil prices and, for the first time in decades, grain prices. The global backdrop, however, will have to be weighed against the resilient domestic economy whose growth potential may be affected by high oil prices. Whether the US Fed rate cut stimulates the US economy or not, certainly it should persuade the RBI to effect a similar cut in domestic rates to maintain even the pegged down growth of 8.5 per cent. Since inflation has fallen to below five per cent and the Consumer Price Index based inflation is around that level, there is no reason why the RBI should not go soft on interest rates. If the IMF is correct in being cautious about a slowdown in the West, India may suffer on account of export dips. But the domestic market should more than compensate. Hopefully, the RBI will inject some boldness in interest rate policy even as it attempts to protect the economy from global shocks.

The US Fed rate cut may encourage investors there to funnel more capital into India, adding to the RBI’s headaches; M{-3} growth has slowed but it is still too high. Sterilisation is expensive and the Budget will reveal by just how much. That is an added incentive to cut rates and lessen rate differentials, especially since another Fed cut is imminent. In the event, the rupee would stabilise and liquidity-stoked inflation would ease up. What more can monetary policy wish for?

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