Assuming normal monsoons later this year, a 100 bps reduction in rates can be expected
In a double surprise, RBI has added zing to the markets which were trying to guess whether a rate-cut will be announced in the credit policy in February or after the Budget.
The first surprise was announcing a rate-cut between two policies. It is not, however, completely out of the blue as the earlier policy statement did clearly note that RBI would not wait for the policy cycle to end to lower rates if it was convinced that inflation and its future trajectory were both acceptable. One could still argue that waiting for another three weeks would not have mattered as there would be no new view on inflation anyway.
The second surprise was that the announcement of the cut was made in the morning, just before the markets commenced operations rather than Wednesday evening. In the past, we have had such surprise announcements but they were made in after-market hours, after 5:30 p.m.
The concept of a surprise is always novel for monetary policy as there is a school of thought which believes that unless there is a surprise element, the impact of monetary policy is less potent. This is not incorrect as, often, when rates are increased or decreased by RBI in line with market expectations, the market remains unperturbed as it has already factored the move ahead of the policy. Therefore, a surprise policy change is normally more effective. However, making such surprise policy changes a habit will increase volatility in the market as players would always keep guessing when RBI would intervene.
Curiously, the goal behind having a series of monetary policies that ranged from 8 to 6 (as is the case at present) was to remove this ‘noise’ factor. One may recollect that in the days when rate changes were announced in between policies, there would be considerable distortions in the market as everyone would guess when RBI would come up with a rate change. Such conjectures do cause upheaval in the markets which involve considerable sums of money as trading moves in different direction. G-Secs, stocks, money markets, currencies all tend to be affected by such conjectures.
Normally, the central bank reserves the right to intervene at any time, but this is done when there are serious problems in the economy. In 2013, for example, when the rupee went down, there were emergency measures announced concerning the LAF and rates to ensure that there was order. But by making such an announcement when things are going right, a new dimension has been added to the process of conduct of monetary policy.
While it may be interesting to ponder why this move was made, two implications stand out. The first is that RBI is convinced that inflation has come down and will remain within range. Also, the 6%-mark is what one can infer to be the target for RBI, even in the short-run. Further, speculation of how the inflation numbers will behave after November, when the base effect wears off, has been put to rest given the central bank quite clearly expects CPI inflation to stay within this mark. Given the fact that the announcement was made after the WPI inflation numbers were out, the takeaway is that while CPI inflation is being targeted overtly, the WPI also matters. While WPI inflation always tends to be lower than CPI inflation, it still is something to be monitored.
The second implication is that we can see this rate-cut as the beginning of a series of similar rate-cuts during the year. The scale and pace will be largely determined by the actual CPI inflation and expectations of the same. Given the preponderance of the food basket in the retail price index, inflation tends to be driven a lot by the state of monsoons and hence, it may be expected that while the direction of rates is southwards, it would be calibrated with momentum picking up only after a clearer picture emerges on the state of monsoon after June. On the whole, assuming a normal monsoon, one can expect a 100 bps reduction in interest rates during the course of the calendar year 2015.
Two questions that would be asked are whether or not industry would be happy with this announcement and whether banks would follow suit with rate cuts. Industry would take heart mainly since the rate-cut was long overdue and something which has been asked for very often in the last 2-3 months. Therefore, this will prove positive for industry. However, it will not lead to a flush of investment as there will be a wait-and-watch period for investors. Infrastructure projects would wait for further cuts as money borrowed has to be committed for a long fixed tenure. Manufacturing, with 70% capacity utilisation in the face of stagnant demand, would not be in a hurry to invest more at the moment and will prefer to see demand revive first.
On the second issue, RBI will be keenly observing whether or not banks lower their interest rates. Anecdotal experience shows that when RBI cuts rates, banks are quicker to lower deposit rates than lending rates. There is normally a lag between the two, and when the lowering of lending rates does happen, the extent of reduction is lower than that on deposits. Also, there is a tendency to lower interest rates on the retail portfolio and the decision to do so on the corporate loan portfolio will be driven a lot by the credit risk perception of banks.
The lowering of interest rates by RBI is good news as it provides clear direction to the markets. However, it will be interesting to see whether in future such actions will be generated in the normal course of economic activity between two policies. If so, the market will always try to guess such action, and one can expect considerable volatility in the financial markets when such expectations are triggered. The surprise rate-cut impact has been manifested immediately in the form of lower interest rates, stronger currency and rising stock markets.
And at an ideological level, if we are going to pursue the policy of acting on an ‘as and when when required’ basis, then should we revert to the conventional bi-annual policy approach?
The author is chief economist, CARE Ratings. Views are personal