"The fiscal consolidation programme, while delayed, may compensate in quality, especially if state governments are cooperative. Given low capacity utilisation and still-weak indicators of production and credit off-take, it is appropriate for the Reserve Bank to be pre-emptive in its policy action to utilise available space for monetary accommodation," Rajan explains.
RBI is of the opinion that softer readings on inflation are expected to come in through the first half of 2015-16 before firming up to below 6% in the second half.
According to Rajan, "The need to act outside the policy review cycle is prompted by two factors: First, while the next bi-monthly policy statement will be issued on April 7, 2015 the still weak state of certain sectors of the economy as well as the global trend towards easing suggests that any policy action should be anticipatory once sufficient data support the policy stance. Second, with the release of the agreement on the monetary policy framework, it is appropriate for the Reserve Bank to offer guidance on how it will implement the mandate."
We take a look at six key reasons that led Rajan to cut repo rate:
1) Reforms in Budget: There are many important and valuable structural reforms embedded in this Budget, which will help improve supply over the medium term, says Rajan. "In the short run, however, the postponement of fiscal consolidation to the 3 per cent target by one year will add to aggregate demand. At a time of accelerating economic recovery, this is, prima facie, a source for concern from the standpoint of aggregate demand management, especially with large borrowings intended for public sector enterprises," he warns.
Rajan is however quick to add, "Some factors mitigate the concern. The government has emphasized its desire to clean up legacy issues which gave a misleading picture of the true extent of fiscal rectitude, and has also moderated the optimism in its projections. To this extent, the true quantum of fiscal consolidation may be higher than in the headline numbers," Rajan feels.
"Also, the government is transferring a significantly larger amount to the states, without entirely devolving responsibility for funding central programmes. To the extent that state budget deficits narrow, the general fiscal deficit will be lower."
2) Cutting subsidies: Rajan goes on to acknowledge that supported by lower international energy prices, there is a welcome intent to shift from spending on subsidies to spending on infrastructure, and to better target and further reduce subsidies through direct transfers.
3) Inflation targeting: The central government has signed a memorandum with the Reserve Bank setting out clear inflation objectives for the latter. "This makes explicit what was implicit before - that the government and the Reserve Bank have common objectives and that fiscal and monetary policy will work in a complementary way," Rajan explains.
"In sum, then, the government intends to compensate for the delay in fiscal consolidation with a commitment to an improvement in the quality of adjustment," he adds.
4) New GDP data: According to Rajan, the Central Statistical Organisation is to be commended on the changes it has made to the methodology of estimating GDP, bringing India up to international best practice.
"Yet the picture it presents of a robust economy, with growth having picked up significantly over the last three years, is at odds with still-low direct measures of growth of production, credit, imports and capacity utilisation as well as with anecdotal evidence on the state of the economic cycle," Rajan says.
"Nevertheless, the picture of a steadily recovering economy appears right," he adds.
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