Why RBI has to ensure rate cut gets effectively transmitted to economy

April 09, 2019 7:16 PM

The RBI MPC policy was in line with expectations with the 25 bps repo rate cut and unchanged neutral stance.

external benchmarking rule will not effective from april 2019With growth under some stress, the more pertinent question will be the transmission of rate cuts.
  •  By Suvodeep Rakshit

The RBI MPC policy was in line with expectations with the 25 bps repo rate cut and unchanged neutral stance. Even as the MPC revised its inflation and growth forecasts lower, it sounded cautious on upside risks to inflation. However, the policy action seemed to be hinged on economic growth concerns. There is still some room for the RBI to cut repo rate in 1HFY20, possibly in August rather than June as the MPC watches the outcomes related to election, monsoons, and budget.

For now, growth seems to be a bigger concern for the MPC, especially as inflation remains under control as per its own estimates. In fact, the RBI highlighted that “… the MPC notes that the output gap remains negative and the domestic economy is facing headwinds, especially on the global front. The need is to strengthen domestic growth impulses by spurring private investment which has remained sluggish…” The Monetary Policy Report estimates FY2021 growth at 7.4% after FY2020 growth at 7.2%—implying that there is not much growth impulse going forward.

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With growth under some stress, the more pertinent question will be the transmission of rate cuts. It is difficult for the banks to pass on rate cuts in a liquidity deficit situation (The opposite holds in a rate hike cycle). The liquidity situation needs to evolve with the MPC’s policy stance. To that effect, a re-think of the liquidity framework consistent with the monetary policy stance is essential. If rate cuts transmission need to be quick, it is essential that liquidity be kept close to neutral to marginally positive.

The liquidity situation over the medium term will be aided with the decision to increase FALLCR by 2 ppt over the next one year (freeing up around Rs650 bn each quarter for productive use). However, this could be negative for bonds due to potential lower demand, especially in year of heavy bond supplies.

The MPC expects inflation to be under the 4% mark for an extended period (Monetary Policy Report estimates inflation inching to 4% in FY2021). However, in the near term the following risks will likely keep the RBI cautious on inflation: (1) risks of a weak monsoon (possibility of El Nino) could increase 4QFY20 inflation estimate by around 50 bps, (2) hazy outlook on crude price movements, and (3) fiscal situation of the general government. We estimate that the inflation could hit the 4% mark faster and could restrict RBI’s room for deeper rate cuts.

The RBI preferred to continue with a cautious approach in the April policy. It makes sense too for a central bank given the historical volatility in inflation emanating from food prices and global crude prices. At the same time with inflation expected to stay around the RBI’s comfort level of 4% for an extended period, there remains scope for another rate cut. The window for the RBI to support growth may be limited and within that window the RBI will have to ensure the policy stance gets effectively transmitted to the economy.

The author is Senior Economist, Kotak Institutional Equities. The views expressed are the author’s own.

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