Strong Case For RBI To Cut Rates Now, May Not Have Room Later

The current economic indicators do make a case for rate action: HDFC Bank’s Abheek Barua

Urjit Patel, governor of the Reserve Bank of India speaks during a news conference in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)
Urjit Patel, governor of the Reserve Bank of India speaks during a news conference in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

Monetary policy analysts in India tend to work with some thumb-rules. One such rule is that good fiscal behaviour is to be rewarded with monetary policy easing. From that perspective, the fact that the union budget on February 1 reaffirmed the government’s commitment towards fiscal consolidation - and based its 3.2 percent fiscal deficit projections on some fairly credible macro forecasts - should mean that the RBI will cut its policy rate by a quarter of a percentage point at the end of its two-day meeting on February 8, 2017.

Current economic indicators do make a case for rate action.

1. Demonetisation might not have wrecked the economy but has caused some deceleration. Some of this could be reversed through cash-replenishment but a helping hand from lower interest rates is welcome.

2. Consumer inflation is remarkably low and even if the base-effect turns unfavourable in the coming months, the prints should be well within the target of 5 per cent.

3. The more chronic problems of the economy such as the paucity of private capital formation and mounting bad loans remain. A lower policy rate, it transmitted to actual lending rates of banks could provide relief, albeit marginal, on both fronts.

Thus, there is indeed a somewhat compelling case for cutting the repo rate this month.

The Room For More Rate Cuts Might Be Limited Going Forward

Global commodity prices are increasing. The production cuts by OPEC and non-OPEC oil producers might not push prices through the roof, but appear to have put a decisive end to the exceptionally low oil price regime that undergirded the global economy for the last couple of years.

Industrial metal prices have moved up steadily and could go up further, were the Trump administration to actually produce the large fiscal stimulus that the US president promised on his campaign trail.

The rise in input prices is captured in the convergence in inflation measured by the retail consumer price index and the input-heavy wholesale price index.

The gap between the two inflation indicators was at its peak in September 2015 at 9 percentage points. WPI grew at 3.15 percent and CPI 3.63 percent in November, leaving a 0.48 percentage point gap between the two indices. The implication of all this is that there is a significant risk of rising inflation going forward.

Currency Moves May Require Holding Rates Down The Road

There is also the business of global capital flows and the exchange rate that most central banks tend to be squeamish about discussing at length. These nevertheless exert an influence on monetary policy.

There is a strong view that dollar flows could return to the US both in response to higher US rates and the “America First” policy that would both punish offshoring and reward domestic production.

This has the potential to drive the rupee down sharply and the textbook defence against unwarranted depreciation is to hold if not raise policy rates. The risk of China suddenly floating its currency remains, if it is pushed to a corner by the US. That would effectively result in massive depreciation in the Yuan. Holding the interest rate in the future might be sensible from that perspective too.

The Market Is Already Sending Lending Rates Lower

However, this monetary policy meeting might be a bit of a side-show as far as its impact on credit and bond markets goes.

  • Demonetisation has resulted in large deposits for banks and the system has a liquidity surplus of roughly Rs 3 lakh crore at last count, unprecedented for this time of the year, when deficits are the norm.
  • The credit-deposit ratio is down to about 70 percent, a good 5 percentage points from the level a couple of years ago. Short term funding rates are consequently low.
  • Both the dictates of formula-based pricing (the MCLR), and the chase for assets should induce a drop in actual lending rates.
  • The government net market borrowing figure of Rs 3.48 lakh crore is way below the market’s expectations, thanks to an anticipated surge in small savings. The competition from government borrowings will be relatively muted.

The asset chase and associated drop in lending rates is already visible in the retail credit market and should become more visible for corporate lending.

Were the RBI to cut rates in the coming policy meeting, it might just be catching up with a curve that is headed south.

Abheek Barua is the chief economist and a senior vice president at HDFC Bank.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.