Not surprisingly, given its earlier stance, RBI did not cut repo rates and, instead, focused on the 1.9 ppt rise in CPI since its last meeting—consumer inflation rose from 1.5% in June 2017 to 3.4% in August—being a sign of increased inflationary pressures. It ignored the fact that, with CPI falling from 5.8% in June 2016 to 5% in August 2016, much of the inflation was due to the base effect. Also, since inflation continued to fall even after August 2016—till January 2017—CPI will remain high over the next few months, making even a December cut look difficult. RBI’s refusal to cut rates is odd since its FY18 CPI estimate is 4.6%, well within the comfort zone of the 4±2% target.
It makes even less sense since, given the low demand, RBI has slashed its FY18 GVA target to 6.7% from 7.3% made just two months ago. An accommodative monetary policy was needed since, at a decadal high of 6%, the real interest rate is stifling demand. Indeed, with RBI acknowledging the likelihood of the output gap rising, it is difficult to see where inflationary pressures will emerge from—the manufacturing sector grew by 1.2% in Q1FY18, the lowest in 20 quarters.
The most likely source, RBI feels, will be the slippage in the fiscal deficits of the Centre and states. RBI talks of the loan waivers various states have promised and the likely central stimulus taking the combined deficit up by 100 bps in FY18. This, it says, can cause a 50 bps hike in CPI. But it is not clear if this equation holds, especially in a low-aggregate-demand situation—as now—when there is also so much unused industrial capacity. In the last five years when the combined deficit was high, but fell slightly from 6.8% in 2013 to a likely 6.3% in 2017, CPI collapsed from 9.4% to 3.7%. Between 2005 and 2010, the combined deficit rose from 7.3% to 9% while inflation rose dramatically, from 4.2% to 10.5%. And while deficit levels remained high but fell slightly, from 9.5% in 1998 to 8.8% in 2004, CPI crashed from 13.3% to 3.9%. In short, the correlation—and what matters more, causality—seems weak. Where RBI has a point, is that banks have not passed on all the repo cuts—between December 2014 and now, while the repo was cut by 200 bps, the weighted average lending rate of banks fell by 125 bps. RBI’s new methodology, if accepted, could force banks to pass on more of the rate cuts to all customers—the MCLR methodology only helps new borrowers. Perhaps the government also needs to persuade PSU banks to pass on the repo cuts fully; the catch is that until the government gives banks more capital, not passing on the full rate cuts is the only option available to them to shore up balance-sheets.