RBI Has Ef­fec­tively De­liv­ered a Larger Cut


The Economic Times - - Economy - SONAL VARMA

Go­ing into the April pol­icy meet­ing, even as con­sen­sus veered to­wards a 25 ba­sis points rate cut, hopes of a 50 bps cut were alive. While the 25 bps repo rate cut would have dis­ap­pointed a few, the RBI has ef­fec­tively de­liv­ered a larger cut. Here’s why:

Be­fore the April cut, the RBI’s 125 bps repo rate re­duc­tion had trans­lated into only a ~70 bps re­duc­tion in lend­ing rates. Tight liq­uid­ity was one of the rea­sons. In this re­gard, the RBI’s com­mit­ment to lower the av­er­age ex ante liq­uid­ity deficit from 1% of net de­mand and time lia- bil­i­ties to close to neu­tral over a pe­riod of time is very im­por­tant, as it im­plies that the weighted-av­er­age call money rate, which was hov­er­ing around 15 bps over the repo rate, will inch closer to the repo rate. Hence, the fall in call rates will be more than the 25 bps de­cline in the repo rate. Since the overnight call rate is what re­ally mat­ters for pol­icy trans­mis­sion, the ef­fec­tive rate cut will ac­tu­ally be greater than 25 bps.

Along with a prom­ise for more liq­uid­ity, the RBI also said that it re­mains ac­com­moda­tive, thereby leav­ing the door open for more eas­ing. Hav­ing de­liv­ered 150 bps of cu­mu­la­tive cuts al­ready, how much more space is re­ally left? Not much, in our view.

In its base­line, the RBI sees CPI in­fla­tion mod­er­at­ing to 5.1% y-o-y by Q1 2017 and to 4.2% by Q1 2018, which looks dif­fi­cult to achieve, in our view. Most of the cycli­cal fac­tors that drove sharp dis­in­fla­tion ap­pear to be be­hind us: Oil prices have bot­tomed out, ru­ral wage growth is sta­bil­is­ing, and the out­put gap, while still neg­a­tive, is clos­ing at a grad­ual pace.

And there are up­side risks to in­fla­tion from the im­ple­men­ta­tion of the Sev­enth Pay Com­mis­sion rec­om­men­da­tions. Plus, a nor­mal mon­soon is no panacea. Over the last 15 years, the cor­re­la­tion be­tween mon­soon rain­fall (% de­vi­a­tion from nor­mal) and food in­fla­tion has been a lowly 0.14.

Even as the cycli­cal fac­tors be­hind lower in­fla­tion have largely played out, the struc­tural fac­tors that drive in­fla­tion such as the level of cap­i­tal stock, pro­duc­tiv­ity and low in­fla­tion ex­pec­ta­tions are yet to fully play out. In fact, our anal­y­sis sug­gests that the steady state of CPI in­fla­tion, with no out­put gap, is still about 5.5%. This sug­gests to us that in­fla­tion is un­likely to sus­tain­ably un­der­shoot the RBI’s tar­get of 5% for March 2017 and the like­li­hood of it mov­ing to­wards 4% by March 2017 is very low. Hence, the RBI will be cau­tious in low­er­ing rates fur­ther, in our view.

Rather than more repo rate cuts, we be­lieve the fo­cus of mone­tary pol­icy will re­main to­wards en­abling greater trans­mis­sion, which cur­rently means more liq­uid­ity in­jec­tions ei­ther via USD pur­chases (if cap­i­tal flows are strong) or via open mar­ket bond buy­backs.

Over­all, bar­ring a sig­nif­i­cant global shock, we ex­pect less ac­tion on rates and much more on the trans­mis­sion mech­a­nism in the com­ing months. (Sonal Varma is ex­ec­u­tive

di­rec­tor, No­mura.)

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