Next RBI rate cut not before April

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In his post-policy interaction with the media on Tuesday, Reserve Bank of India (RBI) governor Raghuram Rajan reaffirmed the central bank’s accommodative stance in no uncertain terms—something he had done in September too.

However, there is a subtle difference between its latest policy, unveiled on Tuesday, and the last, on 29 September.

Last time, after announcing a surprise half a percentage point rate cut, bringing down the policy rate to 6.75%, the policy document had said its stance would “continue to be accommodative”, hinting at more rate cuts in future. This time around, it says, “the Reserve Bank will use the space for further accommodation, when available”.

Clearly, there is no certainty about the timing of the next round of rate cuts.

There are three possibilities.

One, on 2 February when RBI announces its next policy. This can only happen if the government is able to convince the central bank that it will take appropriate steps in the Union budget—to be announced in end-February—for containing fiscal deficit at 3.5% of GDP despite the implementation of the Seventh Pay Commission proposals and the quality of its spending; there is no compromise on capital expenditure.

Two, immediately after the presentation of the Union budget. If RBI is hugely impressed with the government’s commitment to contain fiscal deficit and supply side management that can dampen food inflation and a cut in small savings rates that enables banks to pare their deposit rates, it may go for yet another out-of-turn rate cut and not wait for the April policy.

Three, it can only happen in the April policy review, provided all other conditions remain conducive such as low commodity prices, inflation well within the central bank’s projection and not too much disruption in the market after the likely US Federal Reserve’s rate hike on 16 December. While the rate hike is a near certainty, the Federal Reserve can go slow in its actions in future.

I would bet on the next rate cut in April, and that too only if there is “space for further accommodation”. RBI is more cautious now than it was in September. There are reasons behind this. The US rate hike is almost a reality now. Apart from that, the proposed pay hike of the central government employees will have an impact on inflation and fiscal deficit although the government can neutralise its direct effect on aggregate demand by budgetary tightening if it does not deviate from its commitment to fiscal consolidation.

RBI has kept the GDP target unchanged at 7.4% for fiscal year 2016 and retail inflation target at 5% for March 2017. Inflation has been rising since August and will continue to do so till December before plateauing.

The challenge before the central bank at this point is monetary transmission. Although the policy rate has been cut by 1.25 percentage points since January, the banks have cut their minimum lending rate by less than half that. It will come down further only when banks start calculating their minimum loan rate, based on the marginal cost of funds—something which RBI has been pushing them to do. A cut in small savings rate will also encourage banks to reduce their deposit rates and once their marginal cost of funds comes down, they will be able to pare the loan rate. RBI is also hopeful that once the banks are able to clean up their balance sheets of the pile of bad loans, credit offtake will pick up.

The message to the banking system and the government is pretty clear. Banks should start passing on the benefit of a series of rate cuts that happened between January and September to their borrowers before expecting yet another rate cut, which can happen only if the government does not lose sight of fiscal consolidation and actively manages supply side issues to tame food inflation.

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