The Finance Minister P Chidambaram in an interview to a leading economic daily recently suggested that the RBI should "fall in step with the government".
Commenting on the government decision to hike diesel recently, Prime Minister's Economic Advisory Council Chairman (PMEAC) C Rangarajan said, "We have to keep balance in price of diesel and petrol. Recently, we have on several occasions but we have not acted on diesel. I think the opportunity of action for RBI is provided by this action of the government...The government has showed that it can take a very hard decision."
"The RBI may ease rates as there is a strong case for interest rate reduction. The RBI is as concerned about growth as the government is," Department of Economic Affairs Secretary Arvind Mayaram told CNBC-TV18 recently.
The government has its own agenda in lowering interest rates. It has a huge borrowing programme and lower interest rates is definitely a boon to it. Also, lower interest rates means buoyant stock markets, enabling the government's own divestment programme (it plans to sell shares in government owned entities).
But, are lower interest rates really warranted? Certainly not when inflation is high. The Financial crisis after the Lehman Brothers collapse largely erupted as asset bubbles were created due to low interest rates. Also, one can hardly justify lower interest rates when inflation, particularly core inflation is above 10%. By lowering interest rates when inflation is high could lead to negative real returns for investors in fixed income securities. Already the recent diesel hike is likely to lead to further pressure on inflation in the next few months. In fact, analysts believe that WPI inflation could be headed for 8% as commodity prices are likely to rally owing to huge monetary easing in the West.
The government at this juncture seems bent on appeasing foreign investors and credit rating agencies and is less worried about the common man. Higher interest rates could help fight inflation, though growth can be affected to some extent. However, fighting inflation at this juncture is more important and a little growth can be sacrificed. It would be interesting to see if the RBI monetary policy review on October 31, 2012, results in a cut in repo rates (interest rates).
The government in the meantime should stop suggesting what the RBI needs to do and leave the institution which is mandated with monetary measures to decide independently. An interest rate cut is certainly not warranted.