Why Raghuram Rajan finally cut the repo rate


I have never run a full marathon, and my wife will not let me run one…She says that’s tempting fate. – Raghuram Rajan in an interview to The New York Times

I am not an early riser. These days with no full time job, I rarely wake up before 10 AM. Yesterday was not any different and by the time I woke up, I had already got a few messages on WhatsApp from friends and ex-colleagues informing me that Raghuram Rajan, governor of the Reserve Bank of India (RBI), had finally cut the repo rate.
Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans. Rajan cut the repo rate by 25 basis points(one basis point is one hundredth of a percentage) to 7.75%.
For the past few months there was tremendous political pressure on the governor to cut the repo rate. So what prompted Rajan to finally cut it? “
To some extent, lower than expected inflation has been enabled by the sharper than expected decline in prices of vegetables and fruits since September, ebbing price pressures in respect of cereals, and the large fall in international commodity prices, particularly crude oil…Weak demand conditions have also moderated inflation excluding food and fuel, especially in the reading for December,Rajan said in a statement released early morning yesterday.
The massive crash in crude oil price has contributed to lowering inflation to some extent. But more than that it has helped save precious foreign exchange spent on importing oil. As, Urjit Patel, one of the deputy governors of the Reserve Bank of India (RBI),
recently explained “The dramatic fall in oil prices is a boon for us. It saves, on an annualised basis, around US$ 50 billion, roughly, one-third of our annual gross POL (petroleum, oil and lubricants) imports of about US$ 160 billion.”
The fall in the price of crude oil
as I have pointed out in the past, has also ensured that the government’s fiscal deficit hasn’t gone totally for a toss. Even with the massive fall in crude oil prices the fiscal deficit for the period April to November 2014 was at 99% of the annual target. Now imagine where the fiscal deficit would have been if this fall in crude oil price had not happened.
On December 2, 2014,
the day the Fifth Bi-Monthly Monetary Policy Statement for the last year was released, the Rajan led RBI had kept the repo rate unchanged. The price of the Indian basket of crude oil on December 2, 2014, had stood at $70.08 per barrel. By January 14, 2015, the price of the Indian basket of crude oil had fallen by a massive 38.1% to $43.36 per barrel.
This was a huge change from the time of the last monetary policy statement was released around six weeks back. Clearly, Rajan and the RBI, like almost all other experts, did not see this massive fall in oil price coming.
If that had been the case, the RBI would have cut the repo rate last month itself.
As The New York Times reports: “Mr. Rajan also defended his decision not to lower interest rates at his last monetary policy review in December. While oil prices had already fallen considerably by then, he said there was no way to foresee the abrupt plunge that followed.”
The RBI expects the oil prices to continue to remain low. “Crude prices, barring geo-political shocks, are expected to remain low over the year,” the central bank said yesterday.
Another reason which led to the RBI cutting interest rates in between meetings are the falling inflation expectations (or the expectations that consumers have of what future inflation is likely to be).
As per the previous 
Reserve Bank of India’s Inflation Expectations Survey of Households, the inflationary expectations over the next three months and one year were at 14.6 percent and 16 percent. In the latest inflation expectations survey released yesterday, these numbers have crashed to 8.3% and 8.9% (See chart that follows). “ Households’ inflation expectations have adapted, and both near-term and longer-term inflation expectations have eased to single digits for the first time since September 2009,” Rajan said. This would have been another reason which led the Rajan led RBI to an inter-meeting cut in the repo rate.

Trends in Inflation Perceptions and Expectations

In the statement released on December 2, 2014, RBI had hinted that rate cuts would start in early 2015. “If the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle,” the statement had said.
And that is precisely what the Rajan led RBI has done. It had also said that: “The Reserve Bank has repeatedly indicated that once the monetary policy stance shifts, subsequent policy actions will be consistent with the changed stance.” What this meant in simple English is that once the RBI was convinced that inflation has been brought under control it would cut interest rates rapidly.
Crisil Research expects the RBI to “
cut rates by 50-75 basis points over the next fiscal (i.e. 2015-2016).”
Analysts Chetan Ahya and Upasana Chachra of Morgan Stanley are more bullish. They said in a research note released yesterday: “We believe that this is a beginning of a big rate cut cycle. We expect a further 125bps rate cuts over the next 12 months, cumulative 150bps in this cycle (compared with our earlier forecast of 50bps rate cuts). We expect a further rate cut of 25bps in the next monetary policy review on Feb 3.”
Personally, I don’t think Rajan will cut the repo rate on February 3. He will wait for the government to present the annual budget and then decide further course of action. As he said in yesterday’s statement: “Key to further easing are data that confirm continuing disinflationary pressures.” This means that if inflation keeps falling or remains stable, the RBI will cut the repo rate more in the days to come.
Crisil Resarch pointed out in a research note yesterday: “Retail inflation has stayed within 5% and core inflation [non food-non fuel inflation] continues to decline. Core inflation fell to 5.5% from 5.8% in November, the lowest recorded since the beginning of the new CPI series in 2012. Current momentum suggests inflation could fall below the RBI’s target of 6% by March 31, 2015. Wholesale price index based inflation (WPI) has hit the rock-bottom, coming at 0% in November and 0.11% in December…In addition, the fall in WPI is accompanied by a mirroring decline in the CPI index, something that was missing in 2009. This points to the sustainability of the current disinflationary trend, and strengthens the case for lower policy rates.”
Nevertheless Rajan also said that “also critical would be sustained high quality fiscal consolidation.” As Crisil Research pointed out: “The speed of the cuts will hinge on continued fiscal consolidation, and measures to improve the potential of the economy so that higher GDP growth does not set off fresh price fires.” And that is something to watch out for.
And to decide whether “fiscal consolidation” is happening Rajan would have to wait for the government to present its budget. Another reason why a rate cut is unlikely on February 3 is that no key economic data points are to be released between now and then.

Postscript: Economist Surjit Bhalla told Reuters yesterday that : “If there is a deal between Rajan and Jaitley, that’s very very positive…Monetary and fiscal policy should be coordinated.” This isn’t the best way to approach the issue, for the simple reason that politicians want interest rates to remain low all the time.
Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book 
The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy.
In simple English, what Greenspan means is that the American politicians always wanted low interest rates. India is no different on that front. The current finance minister Arun Jaitley has made several comments in the recent past asking the RBI to cut the repo rate. The previous finance minister P. Chidambaram was no different.
To conclude, it is well worth remembering here what  economist Stephen D King writes in 
When the Money Runs Out “A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 16, 2015