Rate cut will send wrong signals
The worst possible confidence booster is a rate cut now. RBI should hold on to its stance of managing rising inflation expectations despite a sharp fall in economic sentiments globally. A rate cut at this juncture will be seen as a knee jerk reaction to a crisis that has not happened yet. A rate cut will pull down the Rupee, worsen investor confidence in the RBI, take up bond yields and will not achieve anything. Turkey cut rates unexpectedly last week, and the result is a central bank fighting to contain selling pressure on the currency.
The 125bps rate hike over the last three months is indicating RBI’s worries on rising inflation expectations. The fact that global worries started emerging in May 2011 did not deter the RBI from raising interest rates. Equity markets turned weak post April 2011 on worries of Eurozone debt and impending global economic weakness. The three months equity performance up to 25th July 2011 is hardly a sign of positive sentiments over the economy. Equity indices from the Sensex to the Dow returned flat to negative over the three month period from April 25th to July 25th. Hence a sharp fall in equity indices from July 25th to the present where equity indices have fallen between 11% to 19% across markets is no justification for reversing policy stance. It is a different matter altogether that RBI may have erred in the side of caution, but RBI would have been conscious of that fact when raising rates by higher than expected 50bps in their July 26th policy review.
The signal RBI will be sending out by maintaining policy rates at current levels is that the RBI has been right in its assessment of inflation expectations after taking into consideration global economic issues. One or two weeks of market volatility is too early to judge the assessment. The fact that the volatility is caused by high government debt should keep the RBI on its toes, as the Indian government is facing cash flow issues at present and is overdrawn with the RBI by around Rs 30,000 crores to fund its cash requirements. The central bank should be seen as acting on its judgment of inflation and economic growth rather than the state of government finances.
Bond markets have recognized the fact that RBI’s policies coupled with global economic weakness will have a positive effect of bringing down inflation expectations. Ten year benchmark bond yields have dropped by 25bps from July highs on the back of improved sentiments on inflation. A sudden reversal of RBI stance will confuse the markets and bond yields could reverse its downward trend if the market interprets the move differently. A sudden rate cut when the government finances are weak is seen as the central bank trying to support an enhanced borrowing by the government. The market is not ready for higher than budgeted supply of bonds.
Global markets can reverse trends quickly on the back of fresh economic data. Hence a sudden reversal in equity and commodity prices will unnerve markets that have positioned itself on the back of policy reversal by the RBI. The RBI is better off waiting and watching for further signs of commodity weakness before changing its policy stance.
The RBI governor Dr. D. Subbarao has rightfully got a two year extension. Dr. Subbarao has had to cut rates and then hike them in his three year period. He will not want to enter into that cycle again.