RBI Governor D. Subbarao will make his second credit policy announcement on Tuesday, January 27. After a series of steps that helped greatly in easing the liquidity crunch that India faced from the middle of September, market expectations about the RBI’s actions have been largely met as the RBI maintained adequate liquidity in the system. However, today with bank lending rate cuts not keeping pace with RBI rate cuts and credit not expanding as policy makers might have hoped, what should Governor Subbarao do? In addition to cutting rates further, he needs to initiate long-pending reforms that would improve the monetary policy transmission mechanism.

The first question is, should the RBI cut interest rates further? Today there is little disagreement that interest rates need to be lowered further. The real question is whether the RBI should cut rates now, or wait for banks react to its earlier rate cuts. With the latest price data suggesting that the fear of inflation has receded, the concern about a slowdown in growth of output outweighs worries about inflation. There is disagreement on the speed and magnitude of rate cuts. Advocates of gradualism believe that the RBI should wait, just in case inflationary pressures rise again. But today the best policy would be to immediately cut rates sharply.

First, the unfolding of the crisis warrants quick and decisive action. In the past we have seen that the deeper the crisis the longer it takes for the economy to recover. In other words, while we wait and watch and act upon actual data, the economy will continue to deteriorate at a rapid pace. This in turn will make the recovery period slower and longer. India has limited fiscal space and a slow and poor monetary policy transmission mechanism. A 100 basis point cut in the repo rate does not lead to a 100 basis point cut in lending rates immediately. That is why the need for a larger cut in policy rates.

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