BackNext rate cut after budget?
The next set of inflation data, out in mid-February, and the 28 February Union Budget will have a bearing on RBI's monetary policy
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Shall we see yet another rate cut on Tuesday at the monetary policy review? To what extent will the policy rate come down in 2015 and at what pace? These questions reverberate through the Indian financial sector even as a quarter percentage point cut in the policy rate on 15 January, little more than two weeks ahead of the Reserve Bank of India’s (RBI) monetary policy review on 3 February, has kick-started an easy money cycle.
Has anything changed between 15 January and now that could prompt RBI governor Raghuram Rajan to announce another round of rate cuts on Tuesday? The southward movement of international oil prices has been continuing and the European Central Bank (ECB) has joined the Bank of Japan to infuse loads of money into the system. Beginning March, it would spend $68 billion a month purchasing debt to ward off the threat of deflation in the euro zone. While analysts are linking ECB’s so-called quantitative easing with the probable hike in policy rate by the US Federal Reserve—as and when that happens—and Indian financial markets will certainly benefit from the flow of money, this does not influence RBI’s policy review. The next set of inflation data will be out in mid-February. Those and the 28 February Union Budget will have a bearing on the monetary policy. The next rate cut can possibly happen either outside the policy review immediately after the budget, in the first week of March, or in RBI’s annual policy review in April.
RBI has won the war against inflation that Rajan waged in September 2013 immediately after he took over as governor of the central bank. A wide range of disinflationary forces are currently in play, creating space for easing of the policy rate at a fast pace. Along with inflation, household inflation expectations have sharply declined to a five-year low—both near-term and longer-term inflation expectations have eased to single digits for the first time since September 2009. Analysts are expecting anywhere between 50 basis points and 125 basis points rate cut in stages over the next few months on top of the 25 basis points rate cut on 15 January and there is a consensus that the rate cuts will be front-loaded. One basis point is a hundredth of a percentage point.
The drop in oil prices and global commodity prices apart, there are quite a few contributing factors to this. Moderation in food prices is one of them. Despite insufficient rainfall, food prices—the main driver of inflation in recent past—have stabilized because of better food supply management by the government through a series of measures including reduction in import duties and increase in export duties. Lower increase in minimum support prices and weak agriculture growth have also led to the drop in growth in rural wages and this, in turn, has led to weaker rural consumption growth and lower retail inflation. After slipping to zero in November, its lowest since January 2009, India’s wholesale inflation rate came in at 0.11% in December, much lower than what most analysts had expected. The so-called core wholesale inflation, or non-food, non-oil manufacturing inflation, dropped to 1.55%, its lowest in five years. Retail inflation quickened in December—to 5% from 4.4% in November—but far less than what the markets had expected. The retail inflation rate will probably rise a tad in coming months, but it is not expected to cross 5.5% in calendar year 2015, half a percentage point lower than the central bank’s 6% target by January 2016.
Disinflationary pressures, sluggish economic growth and lags in monetary transmission are making a strong case for front-loading the rate cuts. Typically, a policy rate cut takes about six months to translate into a drop in banks’ loan rates. HSBC Global Research expects the bulk of the rate cuts in the first half of 2015 but does not see room for more than a 75 basis points rate cut. Morgan Stanley, in contrast, expects a 125 basis points rate cut in 2015 (in addition to the January quarter percentage point cut) and believes that a delay in rate cut could be counterproductive and slow the pace of economy recovery.
Post the January rate cut, RBI’s policy rate is pegged at 7.75%. As Rajan is comfortable with 1.5-2% real interest rate as neutral rate in the normal phase of the cycle, the scope for rate cut does not seem to be more than 75 basis points (including the 25 basis points rate cut that had already taken place) unless, of course, there is a dramatic drop in inflation. If the average retail inflation in 2015 drops to 5% or even less, we can see even a higher quantum of rate cut. And since banks typically take longer in passing the benefit of lower policy rate to borrowers (the transmission is faster in case of a rate hike), we may see the bulk of the rate cuts between now and June. However, this can happen only if the government plays its role in fiscal consolidation. We cannot have a combination of an easy money policy and a loose fiscal policy. RBI can stick to its easy money policy and go for rapid rate cuts only if the 28 February budget reinforces the Bharatiya Janata Party-led central government’s commitment to fiscal discipline and easing of supply constraints for key inputs such as power, land, minerals and infrastructure. The size of the government’s market borrowing programme in fiscal 2016 and the quality of its spending will also be keenly watched.
Tuesday’s policy review may not be action-packed but it will probably outline the conditionalities for further rate cuts. To that extent, the ball is in the government’s court. If it wants a deeper rate cut to fuel economic growth, the government must ensure that low inflation is here to stay through appropriate policy measures.
Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Financial Services Pvt. Ltd, India’s newest bank in the making. He is also the author of Sahara: The Untold Story and A Bank for the Buck. Email your comments to bankerstrust@livemint.com
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