Why did India’s RBI governor cut rates for a second time so quickly?

The unexpected policy rate cut by the Reserve Bank of India – the second since January – has got a lot of people talking.

Even for central bank governor Raghuram Rajan, who has a tendency to surprise markets, this was a whole new level of surprise. A rate cut takes time to work its way through the economy and it’s unusual for the governor to cut so swiftly for a second time — unless extraordinary circumstances called for it.

And by the look of it, there were no extraordinary circumstances at play. The economy (frequently compared to an elephant) has, admittedly, not recovered from the slow drift path it set upon under the previous government, although under the new administration off Modi, business sentiment has certainly improved.

To be sure, with oil prices tumbling by 50% over the past six months, there was room for further rate cuts. But anyone with a basic understanding of economic history will tell you that commodity prices rarely head in one direction forever.

Cutting too much too soon on the basis of unpredictable oil prices seems like a risky bet for a central bank governor to take.

In the past, energy and food prices, both of which are highly volatile, have been the chief culprits behind soaring retail inflation in India, leading to knock-on effects on manufactured goods and services.

Food prices, in particular, have been constantly fuelled higher by a chronic lack of supply infrastructure. So until something is done about repairing the stretched infrastructure problem, high prices will come back to haunt the Indian economy again.

So, it’s truly unusual for a governor who has been at pains to paint himself as an inflation hawk to turn into a dove on the back of a positive turn of events (lower oil prices) that is not in the least bit under his control.

Here are two ‘conspiracy’ theories about his recent policy action:

One theory is that the government has, in some way, put pressure on Rajan into making the rate cut in return for continued independence for the central bank. It seems plausible, especially given the timing of the rate cut — immediately after Modi’s first annual budget.

Another theory is that Rajan is making some rates cuts to leave room for raising them back up again, should the need arise when the US Federal Reserve starts to hike rates.

The expectation is that the US central bank will announce a rate hike in the second half of this year;  that could lead to some outflows from emerging markets. Lower rates now will give Rajan room to raise rates later to staunch heavy outflows.

We’ll find out if that’s the case in a few quarters.

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