The Hindu Business Line : RBI may cut 25 bps in symbolic move

In the good old days, it was enough if he focused on the domestic economy, its growth prospects and inflation, while cocking an eye on the current account and exchange rate. Last week, the US Federal Reserve, in a rare move, cut its benchmark Fed Funds rate from 4.25 per cent to 3.5 per cent in one go. And this was even before Wall Street opened. The collapse of Asian and European markets before US trading began set off alarm – if not panic – bells in the Fed, prompting its pre-emptive action.

Actually, it was only de jure recognition of a de facto situation. For, in recent years and more particularly in recent times, after the sub-prime eruption, markets have gotten ahead of the Fed. Two year Treasuries were down to 2.5 per cent yield levels well before the cut. The market appears to be practically leading the Fed by the nose.

Some years earlier, the perceptive former Fed Chairman, Mr Alan Greenspan, puzzled over bond yields falling even while the Fed embarked on a series of rate increases, neutralizing the tightening of the central bank. Whatever be the reasons for the divergence, it was the start of markets developing a mind and sense of their own on where interest rates should be.

India is not very different. There have been periods of weeks and months when money rates were well above or below the RBI’s repo and reverse rates. Faced with the irrelevance of its benchmark rates, the central bank was forced to resort to aggressive liquidity management to enforce its will. Thus, in the last year and more, the cash reserve ratio (CRR) was hiked more often than interest rates. It seems the RBI must adjust liquidity to achieve its interest rate targets.

To be fair, the Fed, ECB and the Bank of England too have injected enormous liquidity to bring inter-bank rates in line with the central banks’ rates, as risk premiums soared in the aftermath of the sub-prime write-offs and provisioning and illiquidity of collateral.

Last week’s sharp Fed rate cuts put pressure on the RBI to follow suit. There was already a clamour to lower rates, ignoring the entirely different economic and financial market conditions here. (Contrast – till the other day – our booming stocks and property with the US situation.)

So why would the RBI cut? It knows liquidity management more than rates hold the key.

Lopping 25bps would assuage its critics without materially changing anything. On the other hand, it might force banks to reduce deposit and lending rates, which have not been impacted as much as they should have been by market liquidity.

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