Indian Economy in a Deflationary Mode. Will the Central Bank Continue to Cut rates?

The world is running in circles with this financial crisis that has got all tangled into it without leaving anyone. I know for many this is still a recession stage, but many of the facts point to us that all are in early stage of depression or last stage of recession. But as far as any economy is concerned, all are pointing towards downward growth and India is no exception. Indian economy is in a deflationary mode, but the question is whether central bank will continue to cut rates?

• Easing Inflation: Wholesale Price Index (WPI) slowed to 0.27% (lowest in 33 years) in the week ending March 14 2009 from 0.44% in the week ending March 7 2009 (lowest level in two decades). 2008's base effects, slowing food and fuel prices (fuel price cut in December 2008), commodities, power due to global recession and domestic demand slowdown led the fall in the WPI. But Consumer Price Index (CPI) hasn't eased much compared to WPI (8-11% in mid-March 2009).
• Inflation outlook: While WPI might turn negative by March-end/April on easing supply-side factors, CPI might remain high until late-2009 and might slow only as demand eases. This might constrain rate cuts by RBI. Further cut in fuel prices expected which along with recent cuts in excise and service taxes will drive down inflation further. Credit growth has slowed to 19.6% y/y by mid-Jan 2009. Good agriculture harvest also a positive. Deflationary pressures might continue until the end of 2009
• Mar 4: RBI cut interest rate to 5% from 5.5% (5th time since Oct 2008); reduced reverse repurchase rate to 3.5% from 4% as growth slowed to 5.3% in Q4 2008 along with contracting exports, slowing investment and bank lending. Rate cuts are aimed to provide domestic and FX liquidity, improve credit growth
• Jan 2009: Cash Reserve Ratio(CRR) (5%) unchanged after cutting rates aggressively since late-2008. But RBI extended the special refinance facility and short-term repo facility for banks to meet the funding requirements of MFs, NBFCs and HFCs up to Sep 2009
• Central Bank: "While financial markets continue to function in an orderly manner, India’s growth trajectory has been impacted both by global financial crisis and downturn much deeper and wider than anticipated with declining WPI. Banks should monitor loan portfolio to prevent asset impairment, price risk appropriately but continue to lend to creditworthy enterprises"
• Room to cut rates further since growth forecasts will be revised down amid contracting exports and industrial production (real estate, construction, auto, consumer durables) and slowing capital expenditure and consumer spending, cooling labor market and wage pressures. Aggressive monetary stimulus needs to complement the fiscal stimulus (whose size is constrained by fiscal deficit). Inflation is also trending down sharply giving room for more rate cuts to prevent negative real rates. In spite of liquidity injections, global credit crunch, capital outflows and central bank's foreign exchange interventions are keeping liquidity tight. This is affecting private sector's access to credit as bank lending rates haven't eased much and lending standards to firms and consumers have become stringent. Household and firms' bank Non Performing Assets (NPAs) are rising
• Risks of easing rates: Will exacerbate capital outflows and rupee decline. interbank rates have eased since Q4-08; Will not be sufficient to offset the pull back in private domestic demand in 2009. Banks are also reluctant to cut rates too low, and lend to risky sectors like auto, real estate and are instead preferring to park funds in govt bonds. Aggressive rate cuts, liquidity injection and currency depreciation poses inflation risk during recovery in an economy with structurally strong domestic demand
• Since Oct 2008's liquidity squeeze, spike in overnight call and inter-bank rates and slowing domestic demand, RBI has aggressively cut rates (first time in over 4 years), reducing the amount banks are required to invest in govt bonds to 24% from 25%, easing credit cost and conditions for restructuring loans directed towards small and medium enterprises (SMEs), corporate sector and housing sector, injecting liquidity into banking system, buying back govt bonds, improving credit access to banks, investors, Mutual Funds, easing capital inflows, FX intervention by RBI to contain rupee slide

What others say

• Citi: further interest rate cut or reductions in CRR in April 2009 is expected due to given high fiscal deficits, limited fiscal space, weak macro data, and lowering inflation rate 
• EIU: deflationary impact of global recession and easing commodity prices will persist till 2009-end; central bank is expected to cut interest rate further in Q1 2009
• Kotak: Near-zero WPI may not lead RBI to cut rates since CPI is still high. But quantitative easing by the Fed may lead RBI to step up its open market purchases against large fiscal borrowings but it will still resist private placement of government debt on its balance sheet
• Goldman Sachs: WPI to enter a period of deflation from April until end-2009 due continuing demand destruction and large base effects from 2008. Central bank could cut cash reserve ratio for banks by mid-2009 to provide liquidity but might not cut interest rate further until end of general election in
• Nomura (not Online): Central Bank would cut interest rates in April and June due to soft transmission of stimulus to economy
• DBS: Deterioration in growth is main reason of rate cut; further rate cut expected by April 2009 
• Morgan Stanley: RBI's easing will reduce systemic risks in banking system but won't renew business and consumer sentiment in near-term