A rate cut that looks more tactical

The Reserve Bank of India’s Monetary Policy Committee (MPC) in its maiden sitting on Oct. 04 reduced the central bank’s policy repo rate by 25 basis points, delivering the much sought rate cut as part of the fourth bi-monthly monetary policy statement for 2016-17. The cut came as a resolution of the six-member MPC headed by the Governor Dr. Urjit Patel, who was also presenting the policy announcement for the first time. Interestingly, all six members, who were locked in a day-and-a-half of discussions and analyses, leading to the two page resolution, voted for a rate cut.  The twin firsts – the Committee approach and a new Governor at the helm – coupled with handing down of a rate cut rightaway (though many but not everybody in the market expected it) signal in some senses a start that could raise expectations of more to come.

The MPC resolution has cited many adverse effects on both growth and inflation. These include, slowing global growth (more than anticipated), rise in crude prices, manufacturing-driven contraction witnessed in the industrial sector, elevated  level of household inflation expectation, firming up of input costs in the manufacturing sector including staff costs, declining  workers’ remittances and  flattening of software services.

At the surface, this could be on account of a reasonably good monsoon, a Consumer Price Index-Combined (CPI-C) at a low of 3.74 per cent in August 2016 compared to the target rate of 5 per cent in March 2017,  comfortable liquidity conditions as a consequence of portfolio net inflows, and above all outlook on growth remaining optimistic.

The MPC has of course looked at both sides – growth and inflation – and in fact the accompanying 52-page Monetary Policy report released on Tuesday notes:  “The inflation outlook for 2016-17 has improved, but beyond, close vigilance is required to achieve the prospects of reaching 4 per cent  i.e., the centre of the target band. Robust consumption brightens the outlook for (growth) in 2016-17, but muted private investment and weak global demand may restrain the pace of growth in 2017-18.”

The MPC resolution has cited many adverse effects on both growth and inflation. These include, slowing global growth (more than anticipated), rise in crude prices, manufacturing-driven contraction witnessed in the industrial sector, elevated  level of household inflation expectation, firming up of input costs in the manufacturing sector including staff costs, declining  workers’ remittances and  flattening of software services.

These are a range of uncomfortable  developments. But the MPC has been optimistic on the outlook of food inflation and also expects that the food inflation in the months ahead will moderate, giving credit to the measures the government has taken, especially, it said, with regard to pulses.  Equally, the MPC has recognised the potential adverse effects on inflation from the 7^th pay commission award, increase in minimum wage and possible spillovers through minimum support prices. And yet, in their reasoning, the MPC took the view that the upside risk to five per cent inflation by March 2017 has ebbed out.

Furthermore, in support of the rate reduction, the committee argued that “the momentum of growth is expected to quicken with a normal monsoon raising agricultural growth and rural demand as well as by the stimulus to the urban consumption spending from the pay commission award.” It has retained the growth forecast at 7.6 per cent.

In the above context, it is interesting and instructive to mention that the technical analysis presented in the RBI’s second and third bi–monthly review also maintained 5 per cent inflation at end-March and 7.6 per cent growth in 2016-17. Moreover, broadly, the global outlook has remained unchanged over the last two months.

That raises a whole range of questions that will have an impact on how the MPC system works, what the market expects and how the RBI will work to keep inflation within the band of 4 per cent (+/- 2 percent) that it is now mandated to keep by law. The questions are simple: If the situation is unchanged,  why the rate reduction now;  does it  signal a market friendly approach by the MPC system; what will be the net benefits of 25 basis points rate cut; having taken the plunge in a situation that  still admittedly has upside risks to inflation, how can the MPC ensure that inflation and growth remain at its estimated level; and of course, is this rate cut a one- time measure to keep the markets (and the government) happy and then return to vigil mode?

Clearly, the rate cut at this juncture is more sentiment-driven than fundamental analysis-driven. The market, industry captains, government had a heavy deal of expectations from the MPC on a rate cut. Therefore, the rate cut could be seen as a tactical move to pacify this strong clamor. The way things stand now, no future rate cut will be possible.  Moreover, the full transmission of the previous rate cuts has not been taken place. The rising NPA levels at the banks are fundamentally a serious block to future lending. This issue needs to be addressed as this could be an impediment to credit availability from the banks even to the productive sector.

Even assuming that the benefit of rate reduction is immediately passed on to the lending rate of banks, it is doubtful whether it could substantially raise the credit offtake for the productive sector given the potential global and domestic risks and uncertainties. The business world needs to be convinced that this rate reduction is not cosmetic but sustainable. The MPC statement hardly provides any forward guidance in this regard.

It is important to mention that the MPC resolution for the rate reduction should therefore not be interpreted as the dovish stance. It is important that 5 per cent inflation should be sustained and supply side measures should be effective. The potential pressure of food inflation persists. The crude price rise sooner or later may also add to this pressure. In this light, one could view this as a strategic rate cut as a new team settles into office and begins taking a hard look at the numbers once again.

(Dr. R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR)