RBI Has Effectively Delivered a Larger Cut
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