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The Cut That Heals

Unmindful of the noise, Raghuram Rajan is following the path that he believes in

That was a predictable 'Monetary Policy Tuesday'. Raghuram Rajan maintained his reputation as a hard-headed inflation fighter. The stock markets nose-dived while punters and other stock market types, along with sundry list of business executives lamented that Rajan was killing growth. Obviously, executive branch of the government did not officially complain but there were plenty of media persons who claimed that someone or the other from the government had whispered into their frustration with Rajan into the ears of some chosen ones. All in all, just another no-surprises day.

The only thing that is actually frustrating here is this extraordinary focus that we have on the immediate impact of the current rate cut, the reduced expectation of future rate cuts and its impact on the fate of people's equity investments. Sensible, steady investors, like those who might be running equity fund SIPs over the long-term, would look at the RBI's actions, see the 400 point crash of the Sensex in a matter of hours, and conclude that the RBI Governor has done something terrible to the future of their investments.

Yet, nothing could be further from the truth. The markets' reaction to the rate cut delivered by the RBI Governor--and his comments--was short-termist to the extreme. It was the starkest example of a situation where the interests of the short-term traders and long-term investors were not just divergent, but were completely opposed to each other. The punters wanted a stream of sharp rate cuts because they had all convinced themselves that uninterrupted sharper cuts were coming and anything less would result in dropping stock prices.

In sharp contrast, the interests of the long-term equity investor is best served by an environment where the RBI is focussed on delivering a low-inflation environment while giving a balanced set of rate reductions whenever possible and necessary. Unlike what the stock markets seem to imagine, the RBI's role is not to be a steady supplier of inputs that can be used to talk up stocks. It is, instead, the default supplier of confidence that no matter what, we will have a sensible monetary policy that will peg away relentlessly at inflation but still be responsive to poor growth.

And as for the government and businesses, they want lower rates because they are the big borrowers in the system. Asking them about interest rates is like asking a buyer of any product about what the price of that product should be. It goes without saying that buyers want lower prices. In fact, a large chunk of Indian financial system boils down to the government borrowing from small savers and depositors. This ranges from direct borrowing (post office deposits, for instance) to banks buying treasuries out of the SLR. The immediate and certain effect of lower interest rates will be that effectively, the government will pay households less for these borrowings. The higher growth that is supposed to come from lower rates may or may not come because of other factors, but lower real returns for households' deposits will definitely arrive.

One of the lines of argument that the commentariat often takes against the RBI is that Indian inflation is largely structural and doesn't respond to high interest rates. The argument is that high rates won't easily control inflation so you might as well lower them and look after growth. This may or may not have any truth in it but from the point of the view of the small saver (which is not well-represented in the media) this is a poisonous argument. Deposit rates must offer a real rate of return and thus must remain higher than inflation. Otherwise, the depositor's wealth is being robbed by lenders like businesses and the government.

It thus follows that no matter what happens to growth in the economy, rates drops must follow inflation drops, and not precede them. Clearly, unlike many others, Governor Rajan understands this very well.