Is Mr. Rajan justified in not cutting the rates?

The voice, or may I say cacophony, in the business AND political circles is growing with respect to shifting the focus from the inflation-hawk stance to the forward and growth looking stance. The key argument is that we are well on our way to lower inflation where-as the growth has still not picked up.

The financial minister has also argued for a rate cut to fuel growth but the governor has held his ground firm and the rate cut does not look in sight.

Now being neutral is no fun. My stance/opinion is that it is too early. I am with what the governor thinks on this. Why?

Human factors -

1. The 2 gifts that UPA gave us were - stagflation and a weak rupee. Enter Mr. Rajan - we have seen a steadily declining inflation. However, when we look at the global picture - EU, Japan and to some extent US are struggling with lower inflation - or worse deflation. So India seems out of place in this context. More importantly, having a well respected economist who has been the EA to the PM and carries a global outlook should give him enough credibility when it comes to steering us out of this mess.

2. Might I say that the centre does has some vested interests - albiet not so evil. They would much more like to show a higher growth (which would come with rate cuts and more credit supply) rather than just a lower inflation (Something for which they might not get the credit for at all - I would much rather credit Rajan for that). No doubt, My. Jaitley is pushing for a rate cut.

Practical matters -

1. As pointed out earlier - similar economies are struggling with deflationary pressures. Celebrating a lowering inflation may thus be premature for us.

Source: RBI website.

The inflation has definitely eased. However, the inflation has dipped severely mainly because of a sharp fall in oil prices (yellow line). This is something that is not internal to India. The manufacturing inflation is still above 3% - signalling a shortfall in output. We need to be more sure that the economy has come out of these internal and structural problems before initiating a rate cut.

2. I recently read an article in Mint - The cautious central banker. This argues for a conservative central banker when the government does not have a lot of credibility with regards to tackling inflation. The argument goes as follows -

Nominal wages are sticky since it would be difficult for the companies to revies wages every month. However, a government that is looking for growth would be tempted to reduce wages and increase employment and output through an inflation surprise. Now the problem is that consumers will ultimately see a reduction in real wages, especially in a country where the credibility of the government with respect to tackling inflation is low (consider the populist policies of UPA - fuel and food subsidies that strained the budget deficit). This could later lead to an inflation spiral.

The solution is - as suggested by Rogoff - place a cautious and credible central banker. India has that!

Rajan has consistently argued that the so called inflation-growth trade-off is illusionary. Unless we bring down the inflation, growth seems unfathomable. Inflation is hurting rather than limiting growth! So cutting the rates early and risking an above 7% inflation is too risky!