The Goldilocks problem

Given the fall in retail inflation, even after excluding food and fuel, given the comfort that RBI expressed that some of the risks to inflation had either reduced or not materialised, and given the uncertainties of GDP outlook in the post-demonetisation, post-GST scenario, there was little option for RBI except to cut rates, which they did. But RBI has kept the growth outlook unchanged at 7.3 per cent.

The issue is could the rate cut have been more- say 50 bps?

Some argue that a 50 bps cut would have helped in triggering higher credit flow to the retail sector and small businesses and thereby revive growth. A sharper rate cut could help ease the interest burden on the balance sheets of debt-ridden companies. It could facilitate treasury gains especially for public sector banks. All this can simultaneously alleviate the twin balance sheet problem and help the transmission mechanism as the banking system gets prepared to start lending again. 

The argument given against the rate cut  (as voted by one member) or any cut more than 25 bps (as voted by four members) is that the unprecedented low rate seen is due to base effect, and that outlook for inflation in the second half is higher and closer to the target of 4 per cent.  Also, the growth outlook has not changed. Nevertheless, the inflation outlook gave space for the 25 bps action. The MPC has identified farm loan waivers and implementation of the pay commission award by States as possibly resulting in as high as 100 bps increase in headline inflation over the baseline. Also, vegetable prices are a matter of concern. Concerns have also been expressed by some market watchers of the impact of rate cut on asset prices and liquidity chasing yields without factoring the risks. They say that RBI cannot be unmindful of the impact of sharper rate cut on asset inflation (in this context stock and bond prices).

Given the inflation-targeting framework adopted, it is to be expected that RBI will focus more on ensuring durable inflation closer to the target level as that is what it is accountable for, than on allowing some risk to inflation for the sake of higher growth. In other words, there will always be a bias towards not cutting rates or cutting it only by “baby steps”.

Just right for Goldilocks and the RBI may not be just right for those believing that a sharper cut could lead to higher growth and better balance sheets. The oft-quoted statement of Deputy Governor Viral Acharya addressing the latter is, “It is best for the sake of policy credibility to not mix instruments with objectives they are not meant to target.”

What is interesting is that while RBI notes that the baseline path of headline inflation excluding the HRA impact has fallen below the projection made in June and has pointed out a number of growth negative factors, it has retained its growth projection at 7.3 per cent in view of some positive factors like impact of GST, good harvest and higher budgetary allocation for rural housing roads and bridges. It also expects the Government to do its bit to reinvigorate private investment and remove bottlenecks in infrastructure sector. Some analysts point out that the growth negative indicators like slowing down of government revenue, company sales, bank credit, cement production and passenger vehicles are not consistent with the GDP data.  It is presumed that RBI sees these indicators as representing the short-term impact of demonetisation and transition to GST.

The surplus liquidity continuing in the system that needs RBI to resort to all instruments available to it for absorbing the liquidity and keeping the market in neutral mode is a huge challenge. The surplus liquidity has some what reduced from Rs 4.2 trillion in April to Rs 3.0 trillion in July mainly due to increase in currency in circulation. The positive impact of the 50 bps reduction in the savings bank rate by SBI on its margins will no doubt be affected by the reduction by 25 bps in the reverse repo rate. Even so, as lower deposit rates start impacting the cost of funds, there would be scope for some reduction in lending rates by banks. There is a reasonable confidence that banks will not lose deposits in their savings accounts in view of the link to sweep facility and to other payments system services. On term deposits however there could be some cause for concern and stickiness in rates offered by some banks, as public savings will gravitate more towards the mutual funds and post offices where returns are still higher.

In its statement on developmental and regulatory policies, RBI has laid considerable emphasis on making the transmission mechanism work. It has proposed setting up an internal working group to look into linking credit with market benchmarks, align the base rate better with the cost of bank funds. It has also proposed setting up a Task Force on setting up of a Public Credit Registry for bringing greater efficiency in the assessment and pricing of credit. Other proposals relate to introduction of tripartite repos in corporate bonds, simplified hedging mechanism and fixing a separate limit for FPI for bond futures. 

(The writer is former Deputy Governor of the RBI)