RBI takes big gamble with aggressive rate cut

Written by Indranil Pan | Updated: Apr 18 2012, 08:57am hrs
RBI has surprised the market by front-loading its monetary policy with a more than expected 50bps cut in the repo rate. This action was a bit puzzling as recent communications from RBI had indicated its hawkishness on inflation. Further, such a rate action was not anticipated as Mondays headline WPI inflation data was at 6.89%, a shade lower than the previous reading of 6.95%. And even as the core non-food manufactured price inflation came in lower at around 4.66%, it was mostly out of a base effect from the last year. Incidentally, the month-on-month momentum of core inflation had increased in March compared with February data. No doubt, there was a need for a start to the monetary easing as the current nascent recovery in the industrial-production cycle needs to be nurtured. But the message that RBI also wanted to send out with this aggressive move is that a mere 25 bps cut without a simultaneous reduction in CRR might not have resulted in any effective monetary transmission.

Having frontloaded its monetary policy actions, the monetary policy statement clearly indicates that the scope of further reduction in the policy rate could be extremely limited. This is because RBI guides for the growth to revive to around 7.3% in FY13, which is close to the trend-line growth. Along with growth reverting back to the trend-path, the upside risks to inflation from other sources such as currency depreciation, pass-through of suppressed inflation and food scenario remains strong. Thus, any attempt to push growth further, via a larger easing from the monetary side could turn out to be risky, especially in an atmosphere, where the fiscal containment is still to happen in a sensible way. Thus, in coming days, I would expect RBI to maintain caution on inflation and would crucially track the second round implications of any reduction of suppressed inflation, principally on account of an increase in the domestic administered price of oil. Thus, RBI appears to have taken a big gamble with this aggressive rate change.

However, I believe that this is not the end of the rate cutting cycle for the RBI, though remaining unsure of the timing and the extent of further easing of monetary policy. This is because it remains unclear how much of Mondays action could lead to drop in the corporate borrowing costs in the debt market. True, the 10-year benchmark yield came off to close at 8.35% post policy, but any further softening might look unlikely given the large G-sec supplies. And if this transmission fails to happen, the investment demand in the economy could fail to re-kindled, especially as the policy push from Delhi remains largely absent. Unfortunately, the borrowing programme of the Centre remains large and under the current conditioning of rupee liquidity, the corporate fund requirements could get crowded out.

But, with this aggressive move, RBI has probably bought some time and factor in a larger dose of incremental data to decide on the next move. Monsoon trends and its implication on growth/inflation along with unfolding risk conditions in the global financial markets could be crucial inputs into RBIs future monetary policy action. The second point is especially important as it is likely to have implications for the INR dynamics and in-turn on imported inflation risks.

The author is chief economist at Kotak Mahindra Bank. The views expressed are personal