Small chance of a cut in repo rates in January, it is more likely in early March
Two announcements in the monetary policy review exercise were unusual compared to the normal syntax which we outside analysts are so fond of parsing. One was the line in the statement that read “if current inflation momentum and changes in inflationary expectations continue, … a change in the monetary policy stance is likely early next year, including outside the policy review cycle”. The last time an off-cycle policy change happened (other than the July 15, 2013, hike in MSF rate post the violent volatility in currency) was in July 2010 when a 75 basis points (bps) hike in the repo rate was announced, staggered in two phases. There have been other times when rates were changed, but these were mostly cuts post the 2008 global financial crisis.
Although there is a small chance that an early, off-cycle, late-January 2015 cut might actually materialise (if CPI inflation and industry activity numbers are significantly weaker than expected), the likelihood is actually larger for an early-March 2015 cut, if RBI should choose to wait to read the Budget contours instead of initiating the cut in the next policy meet on February 3. This makes more sense, since the alternative would be to wait till early April, missing precious time before the rate cuts start working to lower cost of funds.
So, assuming that the contingent conditions and expectations are met, the likelihood of rate cuts can be presumed to be high. Or can it? During the course of RBI interactions with research analysts after the policy announcement, Governor Raghuram Rajan, in response to a query on the appropriate neutral real interest rate (i.e., nominal interest rate minus inflation) stated, “Today, world real interest rates are about between 1.5% and 2% depending on the country that you go to; I am talking about long-term real interest rates. So, my guess is that would be approximately where we would go in the normal phase of the cycle”. The following, in the spirit of a semiotic parsing of the statement, is a decomposition of the syntax on how much the repo rate might be feasibly cut.
The 1.5-2% real interest rates are indicative neutral real interest rates—it is clear that this is the operating range. Would this mean that, with the expected CPI inflation over the next year at 6% and the repo rate at 8%, there is a negligible chance of a rate cut? Note, however, the key contingent and conditional phrases: “today”, “long-term real interest rates”, “normal phase of the cycle”.
Rajan had patiently laid out the complexity of analysing real interest rates prior to his indicative target range. There are a wide variety of interest rates and an even larger range of inflation metrics. The basic signaling interest rate is the policy rate, the repo, which anchors the structure of interest rates, the yield curve. RBI fixes this anchor, and ensures appropriate money (liquidity) in the system to keep overnight or ultra short-term rates in a close proximity. Floating out from the anchor repo rate are interest rates on government bonds of different maturities (the sovereign-yield curve) which forms the benchmark for interest rates on other non-government bonds. The shape of the sovereign-yield curve evolves on the basis of economic factors, like the demand and supply of these bonds, inflation expectations, etc. These interest rates are typically higher than sovereign rates of corresponding maturities, given the perception of credit and liquidity risk associated with these papers. Each of these interest rates is relevant to a particular class of borrowers (bond issuers). Banks are one of the more important class of borrowers (through deposits —particularly term deposits, Certificates of Deposit (CD), and other bond issues as part of their Tier-2 capital). Depending on the extent of demand for credit, banks raise funds through term deposits and CDs, which have typically remained around 100-150 bps over the repo rate for funds with maturities of over a year (about 68% of bank term deposits in FY13 were of maturities of less than 2 years). Combined with CD rates, overall cost of funds are also in this range. Pricing in credit risk and margins, cost of funds for bank borrowers have been 200-400 bps above the repo rate.
So, for banks, an effective “real interest rate” would practically mean the difference between the blended cost of funds and the inflation rate. For borrowers, the effective real interest rate would be even higher. In addition, there are a range of inflation rates which are relevant for specific classes of economic agents: CPI inflation for consumers, WPI (in general) for producers. WPI inflation is currently running more than 3 percentage points lower than CPI. This then provides ample room for cutting rates, while still consistent with the Governor’s neutral rate indication.
Then there is the phrase, “normal phase of the cycle”. Is India currently in such a phase? Hardly. Whatever the analytic measure of our “potential” growth rate, there will not be too great an opposition to the hypothesis that growth can (and probably should) be at least a couple of percentage points higher over the next few years. In short, despite the rather grim implications of the Governor’s statement on the perceived neutral real interest rate, there seems indeed to be room for rate cuts.
By Saugata Bhattacharya
The author is senior vice-president and chief economist, Axis Bank