By Prashanta Chandra Panda and Rasananda Panda : It is a catch 22 situation for India’s Reserve Bank of India [RBI] governor Raghuram Rajan, who has to decide next Tuesday, whether to cut interest rates for banks, after US Federal Reserve had withheld the decision to increase interest rates at policy-setting meeting on September 17th 2015.

US Federal Reserve has not raised its interest rate surprising the World. Federal Reserve Chair Ms Janet Yellen moved in synch with growing concerns in the global economy, unpredictability of world financial markets and dull inflation in the domestic economy. Janet had also stated that this decision is transitional hinting at the possibility of interest rate firming up. China’s devaluation of its currency could be the prime reason to hold back the rate hike.

Yellen said, “In light of the heightened uncertainty abroad … the committee judged it appropriate to wait”. Stable domestic market, improvements in the labor market, expected inflation at two per cent could lead to effect the hike next month. Real interest can be arrived at based on the Central Bank interest rate and consumer price index. Looking at the leading markets of USA, Japan and UK, the interest rate hike in India appears to be on the card with real interest rate pegged at close to 3%.

                             Summary of Interest Rate and Inflation of Countries (Source –globalrates.com)

Rajan must be looking at the response of Indian stock market to delay interest rate hike. BSE Sensex rallied over 435 points to 26399.31 points (1.68 per cent growth from 16th September 2015) and the NSE Nifty gaining 130.50 trading at 8029.65 points. With synchronization in monetary policy anticipations, FIIs are expected to avoid the tag of net sellers for the next few months. Unless labour employment situation in US improves, the Fed Reserve is unlikely to touch the interest rate. Yet another concern is the rising cost of hedging due to volatility in the currency market. Dr. Raghuram may take this while making his next move.

Dr. Raghuram knows that effectiveness of monetary policy has to be fine-tuned keeping the market expectations in mind. If industry apprehends subdued demand in the market, the change in the rate of interest is less likely to be effected. The reason is by reducing interest rate the market will have more liquidity that would distort the market by helping speculators.

Major European nations, Japan are experiencing this even at near zero rate of interest. In India higher inflation (compared to the leading economy) has a bearing on the real interest rate and real wages. Prices have not come down even as the annual inflation rate remained low. This clearly indicates that India needs financial and monetary institutions to be more pro-active in reading the goods and commodity market as industrialists and traders appear to be benefitting from the present impasse. Recent instances of cement prices going up is a case in point.

Graph Indian interest rate RBI – interest rates last year Indian interest rate RBI – long-term graph

Falling commodity prices n the world, rising demand, putting the project on fast-track and the government’s push for huge investment in key sector is expected to create opportunities for earnings growth for companies. During 2014-15 fiscal year corporate profits reduced from 5.3 % to 4.2% of GDP. Earnings forecasts are low for the financial year 2015-16. Mahesh Nandurkar, India equity strategist is quite optimist that low commodity prices is going to boost company margins leading to higher return on equity across the board.

Indians have been living with the new inflationary environment. The authorities fear that rate cut could further lead to higher inflation. But the other side of the story is that having lived with years of inflation, people in India may not resent little increase in inflation by rate cut, which may lead to more job creation and higher wages. Proper guesswork on the people’s expectations on the part of the government is imperative.

Hence, RBI can consider making money easier and less expensive by reducing repo rate, reserves to be maintained at RBI, reducing mandatory SLR limit to 21%. This can strengthen bank’s leverage in pumping more money and becoming an influential instrument for fuelling the growth. The central bank’s stance is known through changes in repo (the rate at which banks borrow short-term funds from RBI).

Union finance Ministry is expecting a “favourable” environment for monetary policy move by the RBI. They also take into account of the US Fed’s decision. Rajan is faced with pressures from the Finance Ministry as well as the global economy such as US Fed’s interest rate decision, China’s Yuan devaluation and the slow-down of Asian economy in the recent past.

But, the RBI governor is cautious to read signs of market fundamentals. He does not want a troubled growth based on easy liquidity fuelling price growth based investment rather than capacity utilization uses. It’s now for the RBI governor to decide on interest rate cuts.

Union Minister of State for Finance Jayant Sinha has told “we are in a favourable environment now”. In order to increase the industrial production through “Make in India” and other development projects, it would be desirable for the RBI governor to cut repo rate by 25 basis points (bps) as accepted by 86% of traders and economists polled recently by Economic Times.

Considering that India’s growth rate potential estimated at around 7 to 7.5 % in the current fiscal, reserves for currency controls, fall in crude oil price, global fall in inflation, revival of US growth, disinflation in commodity prices with controlled swings of rupee may motivate Rajan top tinker with interest rate cut in the next week.

We are anticipating a rate fall announcement in the forthcoming monetary policy for helping grow quality money supply. However, knowing Rajan’s professionalism, it is hard to believe that he will bite the bullet, given the retail inflation level in the economy, erratic monsoon affecting the agricultural prices and unusual low crude prices. Over to Mr. Rajan.