Repo rates can’t be based on just food inflation rising
On the face of things, there are enough reasons for RBI to pause in cutting repo rates later today. For one, with unseasonal rains, food prices are once again spiralling—food CPI rose from 1.2% in November to 3.9% in December and 6.1% in January. Two, rural wages are rising a bit and, most important, there has been no transmission of the previous repo cuts by RBI. So, if banks are not dropping their rates, what is the hurry for RBI to cut rates again? Much better, the argument goes, for RBI to wait and see how things pan out instead of having to cut rates now and raise them later if inflation goes out of control. According to this argument, what is preventing the banks from cutting rates is the absence of credit demand—bank credit growth is at a 20-year low and deposits growth at a 51-year low—and that, in turn, is related to structural problems such as the high level of corporate stress as well as high NPAs with banks.
There is some justification to this argument and, to that extent, the government needs to work on getting the bankruptcy law that will help banks recover loans faster. In the cases of sectors like oil and telecom, there is no doubt government policy is faulty and, in areas like agriculture and subsidies, there has been little meaningful reform—unless agriculture grows faster, food inflation won’t get fully controlled. Equally, the government needs to lean on PSU banks a bit, to get them to pass on some part of the rate cuts.
It, however, needs to be kept in mind that monetary transmission always takes time—basically, banks are locked into higher-cost deposits and cannot cut rates until such time that these deposits start getting re-priced. RBI, however, needs to take a longer view and cannot be guided by every monthly spike in food inflation. There is, of course, a view that the 1.5-2% real interest rate that RBI Governor Raghuram Rajan has talked of is itself too high given the rate is 0% in developed economies and 0.6% in east Asia. But even if this is to be taken as a given, with most analysts looking at a 5-5.5% inflation for the year—RBI’s ‘central tendency’ for CPI puts the level at below 6% by January 2016—this still leaves enough room for at least a 50 bps rate cut in FY16. Since there is nothing that has taken place to change the trajectory of disinflation—if anything, with the Chinese economy slowing further and Indian IIP and core infrastructure data showing—even the RBI’s projections should be showing a steady deceleration in consumer inflation. And if RBI is to continue with its rate cuts, banks will also be forced to cut rates sooner rather than later.