The central bank has finally delivered what many in the government and the rest of the economy have been praying for — an interest rate cut. Reserve Bank of India (RBI) Governor D Subbarao has been unshakable in his resolve to tame inflation, despite some not very subtle hints from North Block, but it is only now that he finds the conditions right for easy money. He has not only lowered the rate at which banks borrow overnight from the central bank by a quarter of a percentage point, banks can keep a quarter point less in cash reserves as well, which should add Rs. 18,000 crore to the lendable kitty in the banking system. Besides, the less used medium term bank rate also stands reduced by a quarter point to 8.75%. All these would signal the RBI is now moving into an expansionary credit cycle.
The central bank feels the worst is over on inflation, both at the broader wholesale level and at its non-food, non-energy core. The momentum has eased and as long as global commodity prices stay down, Mr Subbarao does not see inflation rearing its ugly head. There is a hangover from a regime of artificially suppressed energy prices though that will keep popping up in inflation data as the government works at aligning them with international benchmarks. The other loss of momentum — that of economic activity — is a bigger concern with domestic demand choked by a credit squeeze and monetary policy is more sensitive to improving the investment climate. The reduction in the cash reserve ratio plays into this theme.
The new dovish RBI has surprised the street but the pace of interest rate cuts will be bound by the growth-inflation dynamic and the government’s management of the fiscal and trade deficits. The central bank expects the economy to grow 5.5% in 2012-13 and year-end inflation to settle at 6.8% — both being revised downward — and this assessment should keep the credit flow going. Mr Subbarao says what the economy needs now most is investment, but infrastructure and sagging farm yields just might spoil the party. These two belong to the supply side, a territory central bankers view only from a distance. The government may have done quite a bit to revive demand since September 2012, but much more needs to be fixed. Easy money by itself can’t pull rabbits out of the hat.