Twin challenges ahead for RBI

Two weeks ago, Reserve Bank of India (RBI) Governor Raghuram Rajan eased interest rates and reduced the policy rate by 25 basis points to 7.75 per cent.

The timing seemed right as retail inflation was at 5 per cent, much below the targeted 6 per cent by January 2016.

Then, the liquidity situation was comfortable, oil prices  were tumbling, trade deficit was narrowing and the rupee largely stable against the US dollar.

The good run continues and there are expectations of another 25 basis points cut by the RBI in its sixth bi-monthly monetary policy review on Tuesday.

In fact, not much has changed in the past two weeks to demand another cut. However, if the strategy is to pare rates in a measured way, further easing may follow.

Meanwhile, Rajan's eye would be fixed on two big variables.

He would take a close look at the fiscal deficit number, to be announced by Finance Minister Arun Jaitley in his Budget on February 28.

Rajan would also track the pace of the US economic recovery and the Federal Reserve's interest rate policy.

The US has had near zero rates post 2008. These two variables have the potential to hold up the softening of interest rates.

Let's first take the fiscal deficit.

The country's finances have slipped post 2008 and the fiscal deficit has widened in the past few years.

In the current financial year, the deficit has been pegged at 4.1 per cent of the GDP.

A higher fiscal deficit signals higher borrowing by the government to bridge the gap and consequently higher money supply in the  market, fuelling inflation. In the first nine months of 2014/15, the fiscal deficit is  clearly not in the comfort zone.

The deficit has already breached the budgeted figure of Rs 5.31 lakh crore for the full year. Poor tax collections are largely responsible for this trend.

The government, however, is pushing ahead with disinvestment and telecom auctions to bridge the gap.

But even if the government achieves the targeted level of fiscal deficit, there are challenges galore.

In fact, the divestment of government stake in PSUs is also going to reduce dividend income going forward. Rajan will surely look at the big picture and not the fiscal deficit number alone.

The second developing story is the pace of the US economic recovery. A faster-than-expected recovery can lead to greater capital flows into the world's largest economy.

India's equity as well as debt markets have been a beneficiary of  dollar inflows because of a slowdown in the global markets. While Europe, China and Japan  are still struggling, the US recovery could influence monetary policy in India.

Fed Chair Janet Yellen has already given enough signals of a rate hike in the current year.

The dollar is already strengthening and any outflows from India or slowdown in inflows into the Indian debt and equity markets would impact the country's currency, which has been largely stable over the past one year.  

If the rupee depreciates against the US dollar, it has the potential to import inflation into India.