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How long before the RBI cuts rates?

So, the bank rate remains at 6 per cent, reverse repo and repo rates at 6 per cent and 7.75 per cent respectively and the Cash Reserve Ratio (CRR) at 7.5 per cent.

While aware of the deceleration of the GDP growth in comparison with the last year, the bank has preferred to retain its focus on inflation control. It is important to understand its logic.

The inflation is under control, but only apparently. Inflation, based on variations in the wholesale price index (WPI) on a year-on-year basis, eased to 3.93 per cent as on January 19, 2008, far off from its peak of 6.4 per cent at the beginning of the financial year. Inflation based on the consumer price index (CPI) for industrial workers (IW) declined to 5.5 per cent on a year-on-year basis in November 2007 from 6.3 per cent a year ago.

However, RBI has cited three factors to support its view that these numbers represent an "artificially repressed" inflation. First, higher international oil prices have not been passed on to domestic consumers. The price of the Indian basket of international crude has increased steadily in 2007-08 from $66.4 in April-June, $72.7 in July-September and $85.7 in October-December 2007 to $88.9 per barrel as on January 25, 2008. Even after the recent softening of global prices to below $90/barrel and the appreciation in the rupee, the inflationary impact of the correction could take the inflation rate close to the tolerance level of 5 per cent.

Another worrying factor is, of course, food prices. These have gone way beyond the levels that prevailed a year ago, pinching hard the vast multitudes of lower and middle class people. Moreover, "elevated international food prices also pose potential inflationary pressures in the period ahead."

Finally, while bank credit growth has moderated to 22 per cent from 28 per cent in 2006-07 and 32 per cent in 2005-06, money supply continues to grow too fast for comfort. Broad money supply (M3) is currently ruling at 22.4 per cent against the indicative target of 17-17.5 per cent for 2007-08. Besides, the liquidity overhang (surplus cash) in the system comprising the liquidity adjustment facility, the market stabilisation scheme and the cash balances of government, has more than tripled since end-March 2007, posing yet another inflationary threat.

On the other hand, the overall situation on the growth front remains comfortable, despite recent tell-tale signs of deceleration. While growth will be slower this year than in the last, it would still be at least 8.5 per cent-not the kind of growth that stands in the need of policy stimulants.

Perhaps, it was unrealistic to expect the RBI to push ahead with growth at the cost of inflation management in an election year. The indication had already come at the World Economic Forum meet at Davos, where India's finance minister said that between growth and inflation, it was the latter that concerned the poor-and thus the government-more than the former. Obviously, with a general election slightly over a year away-the time span before monetary policy shows effect-the risk of rising prices would weigh very heavily with political leadership.

However, there are reasons to doubt whether the RBI would be able to achieve the objective it has placed on the top and whether its decision would serve the economy well.

Ironically, by abstaining from cutting interest rates, the RBI might have aggravated the problem of inflation. The world would not stand still just because India's central bank has opted for the status quo. The US fed has slashed its target rate to 3 per cent. With that, the interest rate differential between India and the US is now 4.75 per cent, up from 1.5 per cent in April 2006 and around 2.5 per cent a year ago. This wide differential is bound to attract large inflows of foreign capital into India. And it is these inflows, as the RBI acknowledges, which have ensured that there is a liquidity overhang as money supply growth has outstripped credit growth.

These inflows have serious implications for inflation, exchange rate, export competitiveness and growth. The RBI's intention to manage them through "appropriate and decisive" policy measures indicates a commitment to containing rupee appreciation, at least to a non-disruptive pace. That suggests pressures on liquidity and more costly sterilisation.

On the growth front, the RBI could have done better than postponing the rate cut to the next announcement in April, or even beyond. The Indian economy, while growing healthily, is showing sings of exhaustion. The impact of the US slump and high interest rates is now being felt. The GDP growth in the first half of 2007-08 is 9.1 per cent, down from 9.9 per cent a year ago. The Index of Industrial Production fell a percentage point to 9.2 per cent in April-November 2007 while growth in the consumer sector almost halved to 5.2 per cent. The growth dropped to 5 per cent in November. Remarkably, the industrial slowdown is most severe in sectors such as transportation equipment and consumer durables, which are sensitive to interest rates.

Among other indications, the growth of non-food credit has dropped to 22.2 per cent as on January 4, 2008, compared with 31.9 per cent a year ago. Almost all business confidence indices show recent declines. The RBI's own Industrial Outlook Survey expects a fall in industrial activity in this fiscal's fourth quarter. At 8.5 per cent, India's GDP growth this year may seem heady, but year-on-year it is a dip of almost 100 basis points.

The RBI has castigated banks for excessive investments in government securities and is nudging them to cut interest rates, a message explicitly beamed to bank chiefs by the finance minister some time ago. So far banks are not buying; most would prefer to wait for the central bank's next policy statement on April 29.

The question on everybody's mind is: how much must the economy slow down before the growth objective overrides the inflation objective? It would have been far more productive for RBI to reduce rates now, even with the threat of inflation. Higher growth has always been the best medicine for feverish prices, and the domestic economy still has a lot of slack, with the rural sector waiting for investments.

As for controlling food prices, selective credit controls and fiscal measures such as tax on export of rice and other staple food items would be more effective. As to global inflation, it is difficult to frame a policy that could completely insulate an open economy.

In April, it is likely that the inflation may well be at the same level, with growth showing signs of further deceleration. At that point, the RBI's stated commitment to maintaining the growth momentum will be put to test. But the monetary policy then will be aligned not so much with the domestic economy as with the government's perception of its state.

In the meantime, the productive economy at the margin, those small and medium enterprises and new home-loan borrowers will pay high rates while monetary policy tries to solve the paradox of excess liquidity and declining credit.