Assuming a 5.5% CPI, another 50bps on the cards
While RBI Governor Raghuram Rajan has said the quality of the fiscal consolidation and the shift in spending towards infrastructure instead of subsidies is a reason for cutting repo rates, the main reason is the fact that the economy continues to remain quite fragile with investment growth and consumer demand slowing. RBI’s assumption is that, even though a 3.9% of GDP fiscal deficit is higher than the FRBM target of 3.6%, the overall central and state deficit will be lower now that more funds are being transferred to states. After growing 5.6% in May 2014, the already sluggish IIP has been slowing steadily, to minus 4.2% in October, up to 3.9% in November and then down again to 1.7% in December. Core sector growth has fallen from 6.7% in November to 1.8% in January 2015. Not surprisingly, thanks to poor aggregate demand, while CPI inflation fell from 8.6% in January 2014 to 5.1% in January 2015, core CPI fell even more dramatically from 7.8% to 3.9%. Between December 2014 and January 2015, while CPI rose from 4.3% to 5.1%, core inflation continued to fall from 4.3% to 3.9%.
Apart from the weakness in the economy that RBI talks of—“low capacity utilisation and still-weak indicators of production and credit offtake” is how the monetary policy statement puts it—the other reason is the continued global deflation; China has just reduced its policy rates in light of a continuing slowing of economic activity. It also helps, from RBI’s point of view, that the finance ministry has just agreed to sign a monetary policy framework with it, that gives it more autonomy on controlling inflation—FE’s view, though, is the monetary policy framework is biased towards keeping policy rates high (goo.gl/slNUmM)and will be negative for the economy in the long run, a point also made in the accompanying column by Renu Kohli.
Given RBI’s view that the real repo rate needs to be in the region of 1.5-2%, this opens up a considerable window for further cuts in the repo in the course of the year. While the RBI’s ‘central tendency’ for CPI inflation for March 2015 was 7.75% in October 2014, this was reduced to 6% in December 2014, and the last estimates by RBI put the level at below 6% by January 2016. Independent forecasters like Citibank put the FY16 CPI at 5%, and this is a number the budget also talks of. In which case, given the current policy rate of 7.5%, there is at least another 50 bps of a rate cut that can take place in the current year. The ball is now in the court of the banks, and some have said they will call meetings of their ALCOs soon to take a decision—given the fall in wholesale deposit rates, chances are banks will pass at least a part of the rate cut, more so since there will be considerable pressure from the government. A 100 bps cut in interest rates makes real GDP grow by around 20 bps thanks to a boost to both consumer durable and housing demand. While an investment response will take some more time due to stretched corporate balance sheets, any rate cut will have a positive impact on stressed balance sheets.