RBI monetary policy review: Three reasons why Guv Raghuram Rajan did not cut rates by 50 bps

By: | Updated: June 1, 2016 11:10 AM

RBI monetary policy review: In line with market and analysts' expectations, RBI Governor Raghuram Rajan on Tuesday cut the repo rate by 25 basis points...

While a 25 basis points rate cut was on expected lines, Raghuram Rajan disappointed many by not cutting the repo rate by 50 basis points. (Express Photo)While a 25 basis points rate cut was on expected lines, Raghuram Rajan disappointed many by not cutting the repo rate by 50 basis points. (Express Photo)

RBI monetary policy review: In line with market and analysts’ expectations, RBI Governor Raghuram Rajan on Tuesday cut the repo rate by 25 basis points, giving a thumbs up to Modi government’s “commendable” move of sticking to fiscal deficit targets. While acknowledging the government’s special focus on the rural economy, and the expected demand acceleration, Rajan also cautioned against the inflationary effects of the 7th Pay Commission and the recent unseasonal rains.

RBI also cut MSF rate by 75 basis points to 7% and cut the daily CRR maintenance from 95% of the requirement to 90%.

“In the Union Budget for 2016-17, the Government has adhered to the path of fiscal consolidation and this will support the disinflation process going forward. The government has also set out a comprehensive strategy for reinvigorating demand in the rural economy, enhancing the economy’s social and physical infrastructure, and improving the environment for doing business and deepening institutional reform. The implementation of these measures should improve supply conditions and allow efficiency and productivity gains to accrue. Given weak private investment in the face of low capacity utilisation, a reduction in the policy rate by 25 bps will help strengthen activity and aid the Government’s initiatives,”said Rajan, while also stating that the monetary policy stance will remain accommodative going ahead.

While a 25 basis points rate cut was on expected lines, Rajan disappointed many by not cutting the repo rate by 50 basis points. We take a look at three reasons why Rajan did not go for a sweeping 50 bps rate cut:

Inflationary pressures: According to Rajan, inflation has evolved along the projected trajectory and the target set for January 2016 was met with a marginal undershoot. “Going forward, CPI inflation is expected to decelerate modestly and remain around 5% during 2016-17 with small inter-quarter variations. There are uncertainties surrounding this inflation path emanating from recent unseasonal rains, the likely spatial and temporal distribution of monsoon, the low reservoir levels by historical averages, and the strength of the recent upturn in commodity prices, especially oil. The persistence of inflation in certain services warrants watching, while the implementation of the 7th Central Pay Commission awards will impart an upside to the baseline through direct and indirect effects,” he said.

Rajan was however, quick to add that there will be some offsetting downside pressures stemming from tepid demand in the global economy, government’s effective supply side measures keeping a check on food prices, and the Central government’s commendable commitment to fiscal consolidation.

Downside risks to growth: The uneven recovery in growth in 2015-16 is likely to strengthen gradually into 2016-17, assuming a normal monsoon, the likely boost to consumption demand from the implementation of the 7th Pay Commission recommendations and OROP, and continuing monetary policy accommodation, feels the RBOI. “After two consecutive years of deficient monsoon, a normal monsoon would work as a favourable supply shock, strengthening rural demand and augmenting the supply of farm products that also influence inflation,” says Rajan.

On the other hand, Rajan cautions that the fading impact of lower input costs on value addition in manufacturing, persisting corporate sector stress and risk aversion in the banking system, and the weaker global growth and trade outlook could impart a downside to growth outcomes going forward. The GVA growth projection for 2016-17 is accordingly retained at 7.6 per cent, with risks evenly balanced around it.

Transmission of rate cuts: Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates. The reduction in small savings rates announced in March 2016, the substantial refinements in the liquidity management framework announced in this policy review and the introduction of the marginal cost of funds based lending rate (MCLR) should improve transmission and magnify the effects of the current policy rate cut, assures Rajan.

The stance of monetary policy will remain accommodative. The Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up, he concludes.

(This story was originally published on April 5, 2016)

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