Though RBI has predicated its rate action on the monsoon forecast, should it be this forward-looking?
A question that will be still be asked is whether the 25-bps cut in rates RBI announced yesterday could have been a 50-bps one, given that, with inflation at just a little above 5%, the real interest rate is still close to 200 bps—higher than what RBI has been speaking of. However, RBI appears to be very circumspect on future inflation even though it admits that the conventional relationships between monsoon, farm-output and inflation have not always held in the past. It has hence pitched for caution when indicating its outlook and probably imbibed this factor when taking a call on interest rates.
However, RBI’s reaction—through the repo rate changes—have been quite difficult to understand, considering that since the start of 2015, the economic conditions have been virtually unchanged. Inflation has been coming down continuously with growth showing signs of a pick-up. In fact, the WPI-inflation number has come down to all-time lows. The risk of future inflation, though, has always been there with the unseasonal rains creating concern right at the start of this year. The IMD forecast of a sub-normal monsoon this year has cast a gloom on the prospects for kharif crops.
Further, the known uncertainty has always been the Federal Reserve increasing key rates, depending on the recovery in the US and the threat of inflation surfacing again. However, with the growth scenario across the Atlantic getting fuzzy, it looks like a Fed rate-hike is still some time away. Yet, RBI lowered rates twice out of cycle and chose not to do it at the policy review in April. But, this time, it has lowered rates. This has made anticipating policy changes that much tougher. While the markets have been making guesses about RBI’s moves even in between policies, especially after the CPI inflation numbers come out, the same has increased even for the policies where one has to conjecture RBI’s interpretation of the apparently similar economic numbers in another time context.
The inference which one can draw from the latest rate-cut is that this could be the last one for some time, and if at all there are further cuts, they will be contingent on how the inflation number behaves. This also means that we need to track the monsoon carefully to gauge what could be going on in the mind of RBI. Add to this is the uncertainty of the oil prices in global markets which have been showing some upward proclivities in recent times, and it could mean another dosage of inflationary expectations. This can be a dampener for future rate cuts.
The rate cut of 25 bps should, hopefully, be transmitted by banks to the consumer if it has to have any meaningful effect. In the past banks have been quicker to lower deposits rates, but have been less flexible on the lending side, which may be partly attributed to perceived higher credit risk in the light of the growing NPAs. Last time, the banks had followed RBI’s rate cut, but it was more due to the strong statements made by Governor Rajan in his speech.
This time, he has not made such overtures, and while several bank chiefs have said that it will be left to their ALCOs to decide, one hopes that they do lower rates for any impact to be there on the growth process. Interestingly, RBI has pointed out that the markets have been reacting to its rate actions with more alacrity compared to the banks, as evident from the movements in interest rates in the CP and CD markets. This can, going forward, induce competitive spirit among banks which can drive down lending rates in the course of time. Last year, there was also a tendency for corporates to take recourse in the CP market as against conventional bank credit.
However, even on the deposit side, banks will have to assess their own requirement for funds through deposits relative to projections in growth in credit before they decide on lowering these rates. A consideration for banks will still be the rate of interest offered on small savings. Today, deposits yield between 8-8.5% for a tenure of more than one year. With these small savings offering higher rates, there could be a challenge in attracting deposits if rates are lowered any further. This can be a serious consideration for banks when taking a call on interest rate changes.
At an ideological level, an issue to be resolved is: How forward-looking should the monetary authorities be? While future inflation or inflation expectations are important, should monetary policy action be more flexible? There are two thoughts here. The first is that, as we have 6 policies anyway every year, with RBI having the prerogative to intervene anytime, rates can always be increased in case inflationary conditions change. In fact, even in the current context, the market cannot rule out a rate increase in case the monsoon turns out to be adverse, thus increasing prices substantially. RBI has maintained that it would not like to do one thing today and reverse the other tomorrow.
But then monetary policy cannot be looking in only one direction and has to be amenable to fine-tuning.
The second is that, as RBI has stated that poor monsoons may not necessarily lead to higher inflation, are we hurting ourselves or delaying the recovery process by assuming the worst when taking a call on rates? This is worth ruminating over.
The author is chief economist, CARE Ratings. Views are personal