Why Raghuram Rajan won't be wrong to not cut interest rates

It's turning out to be Raghuram Rajan's time.

First, it was Swamy versus Rajan. Then it was the surreptitious news leak that put Rajan's future as RBI governor in a limbo.

And tomorrow we have the monetary policy where, once again, the question is, will he or won't he cut interest rates?

For the average Indian that's all the monetary policy has come to mean. Will my EMIs go down? Can I get a loan at lower rate?

But ironically, as we have it, while Rajan has lowered interest rates by 150 bps in the past year, bringing the policy rate to about 6.5 per cent, effectively banks have not transmitted these cuts.

My home loan rate continues to hover around 10 per cent and this is from a public sector bank. Rajan has on several occasions appealed to the banks to lower interest rates but in the age of bad loans, such mundane issues that directly impact the middle classes have not found too much traction.

So, even as industry on every occasion has taken the opportunity to blame the governor for low uptick in investment from the private sector, the fact is that it has little to do with interest rates and a lot to do with the debatable decisions taken by big business.

Reckless spending and expansion on inflated projections has led to an excess capacity which is unlikely to be fully utilized at least for another year if not more, unless we see a huge surge in demand. According to a Citi India analysis, there was an increase in momentum of rural demand in the fourth quarter of FY 16 (Jan to March 2016).

The year-on-year growth in the rural index has turned positive in March after two years of deceleration. However, according to the report, urban demand index has remained practically unchanged for almost two years with the lack of formal sector job creation and low real wage growth.

A lot of how urban demand fares will depend on the Pay Commission payout, whenever that happens. 

As India embarks on a consumption-led growth model, low interest rates will only be a consequence of many factors, in India's case - a factor of low inflation (which is creeping back up - the consumer price index came in at 5.4 per cent for the month of April from 4.83 per cent in March while the wholesale price index moved into the positive territory after 17 month of negative growth); and US Federal Reserve's rate decision and monsoons. 

Rains with reforms (land, taxation, labour) will play a determining role in turning around more sustainable drivers of consumption - jobs, wages and rural income. Of course, there is room to cut interest rates further, but for now, he can hold tight and let the other drivers do their bit.