RBI Front Loads Rate Cut

The Reserve Bank of India’s (RBI) monetary policy committee (MPC) chose to cut the policy rate while still maintaining that the risks to the retail inflation target of 5% for March 2017 remain on the upside. India Ratings and Research (Ind-Ra) believes this is clearly a case of front loading the rate cut and resting the hope on moderation of food inflation due to a favourable monsoon and its impact on crop production particularly pulses. The MPC in the fourth bi-monthly review for this fiscal reduced the repo rate to 6.25% from 6.5% as against Ind-Ra’s expectation of no rate cut.

In the process, it appears that adequate weightage has not been given to the lethal combination of structural and cyclical components of food inflation, which has more than often surprised on the upside rather than on the downside in the recent past.

Ind-Ra opines that today’s policy easing is unlikely to boost investments and/or consumption in the economy, unless there is effective monetary policy transmission. The manufacturing sector is beset with low capacity utilisation, while corporate balance sheets are stretched and banks are saddled with bad assets. Since January 2015, the policy rate has been reduced by 150bp; however, the transmission to consumers has been at best 40% of policy easing (public sector banks). Only private sector banks reduced the marginal cost of lending rate for one year by 25bp after the last monetary easing of 25bp in April 2016. Deposit rates on term deposits of above 1-year were reduced between 100bp-160bp during December 2014 to September 2016. So, while borrowers are yet to receive the full benefit of the policy rate cut, depositors are feeling the full impact of a reduction in the policy rate. Real interest rate (the difference between 10-year G-sec and retail price inflation) in the economy declined to 2.06% in August 2016 from 3.69% in July 2015.

The RBI’s baseline model forecasts average retail price inflation to be higher than 5% in FY17. Assuming 10-year G-sec to be 7% and retail inflation to be 5% by end-March2017, the real rate of interest works out to be 2.0%. This simply means that there would be some scope for a further monetary easing in the next fiscal, but it will depend on a number of things such as actual retail inflation, how the monsoon plays out in 2017, the global growth and commodity price cycle.

According to the central bank, Consumer Price Index (CPI) inflation was high during April-July 2016, led by a sharp pick-up in food inflation. Although retail inflation moderated to 5.05% (July: 6.1%) in August 2016, households’ expectation of inflation remains on the higher side as captured by the RBI’s September 2016 inflation expectation survey. Households expect inflation to be 9.5% three months ahead and 11.4% one year ahead according to the September 2016 survey. Although respondents to the July-September 2016 industrial outlook survey expect input costs in manufacturing to increase, corporate pricing power will still be stunted due to the slackness in demand and spare capacity in the manufacturing sector.

The MPC expects food inflation to remain contained on several initiatives taken by the government to augment the supply of pulses, which has accounted for 12%-20% of the overall inflation since mid-2015. Food inflation outlook is also likely to improve as the seasonal softening of food prices in early 4QFY17 takes hold. The prices of fruits, vegetables, cereals and pulses, which were the key drivers of food inflation during April-July, may have peaked (seasonal surge) in July 2016. The committee has observed that cost push pressures could emerge from the effect of the yet-to-be-implemented house rent allowances under the 7th Pay Commission award. According to the MPC, house rent allowances will have a direct impact on the headline CPI inflation through an increase in housing inflation (house rents have a weight of 9.5% in the CPI) as and when the revised allowances are awarded.

In the run up to the policy review, the domestic bond market had factored in a 25bp cut in repo rate. While the policy has not opened up any expectation of rate action in the near future, the movement in the bond market will be sensitive to the RBI’s bond purchases and movements in global bond yields.  In the case of surprises in CPI inflation in the coming months, fresh expectation on the rate front will be instrumental to pull down yields further.

The rupee is likely to stay stable with a positive bias, on the back of domestic fundamentals. However, volatility is likely to kick in on account of large Foreign Currency Non-resident (B) deposits maturing in October and November 2016. The referendum in Italy and US elections in early November will be the events to watch out for the currency.

Posted by Anuradha Basumatari
The author is Associate Director – Public Finance, India Ratings & Research