RBI likely to press pause button on rate cuts, but may act later


Planning Commission deputy chairman Montek Singh Ahulwalia ’s statement on Friday that the Reserve Bank of India (RBI) should consider a rate cut on 17 June because underlying inflationary pressures are abating is being interpreted by many as a government nudge to the central bank to stay on the path of monetary easing. But the weakening rupee and a record high current account deficit could play spoilsport. While the rupee recently hit a lifetime low against the dollar, India’s current account deficit gap is projected at around 5% of gross domestic product (GDP) in fiscal year 2013.
India’s wholesale price inflation dropped to a 43-month low of 4.7% in May, from 4.89% in April, on declining prices of fuel and manufactured products. This certainly creates space for a rate cut at RBI’s mid-quarter policy review on Monday. Retail inflation, too, dropped in May to 9.31% from 9.39% in the previous month. Indeed, it was higher than what most analysts had expected, but the positive news is that core retail inflation (that excludes volatile food and fuel prices) in May dropped to 7.4%.
The clamour for rate cuts has been getting louder in the context of slowing growth. Factory output growth was 2.3% year-on-year in April, weaker than what the markets had expected. That’s bad news. An upward revision in the March factory output figure, to 3.4% from the provisional estimate of 2.5%, does not change the scenario dramatically. The HSBC Manufacturing Purchasing Managers’ Index (PMI), which gauges factory activity, also sank to 50.1 in May, its third consecutive decline and the lowest level in 50 months. The analyst community does not give too much importance to manufacturing PMI, a sequential seasonally adjusted measure, but there is no gainsaying the fact that Asia’s third largest economy has not yet got back its growth momentum. In all probability, economic growth in the first quarter of fiscal year 2014 would be lower than what the Central Statistical Organisation has estimated—5.7%. The economy grew 4.8% in the fourth quarter of the year ended 31 March and 5% for the entire fiscal year, its slowest pace in a decade.
Theoretically, the combination of lower inflation and slowing growth encourages a central bank to cut its policy rate, but that may not happen because of the depreciating rupee. The local currency fell to a record 58.99 against the US dollar on 11 June, but since then has bounced back to 57.53. It has depreciated nearly 7.5% against the US currency since May.
A weaker rupee pushes up the cost of imports. For every dollar worth of imports, India will have to spend more local currency and this will have a bearing on inflation. Roughly a 1% depreciation of the rupee pushes up wholesale price inflation by 15-20 basis points (bps). A basis point is one-hundredth of a percentage point. Currency depreciation neutralizes the advantage of a drop in global commodity prices.
The classic central bank policy measure to prevent currency depreciation is to raise interest rates. An increase in the interest rate makes local assets more attractive for foreign investors and ensures an inflow of funds. This is what Indonesia has done. The Indian rupee and Indonesian rupiah have been the worst affected emerging market currencies. Both countries have high current account deficits. Indonesia’s central bank last week raised its policy rate by 25 bps, from 5.75% to 6%, becoming the first Asian central bank to do so since 2011. RBI cannot follow suit at a time when inflation is low and growth is slowing. It will not raise rates to protect the rupee, but will probably press the pause button after cutting its policy rate thrice, by 25 bps each, since January to 7.25%. From its peak, the policy rate is down 125 bps.
Should RBI then cut banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks are required to keep with the central bank, to make monetary transmission effective? Bankers have been strongly pushing for a cut in CRR. This, they say, will enable them to bring down their loan rates. But this, too, is unlikely to happen for two reasons. First, systematic liquidity is not very tight yet. The average daily cash deficit in the financial system in June is around Rs.63,000 crore—less than 1% of total bank deposits. It will rise and cross Rs.1 trillion this week following the advance tax outflow, but still that does not make a case for a cut in CRR. When the currency is under attack from speculators, a central bank typically drains liquidity from the system to deny the banks any scope to use rupee liquidity to punt on the currency. A CRR cut will be counterproductive.
Does this mean the rate-cutting cycle is over in India and from now the rates can go only up? This does not seem to be the case. This policy review could be a pause before another rate cut in July or later. The reason behind this is that the growth impulse is not yet back in the Indian economy and inflation continues to remain low. For RBI, definitely, faltering growth is a bigger concern than inflation, which is under control. The wholesale inflation rate has been below 5% for two consecutive months now and the core inflation rate below 3% for two months. At 2.35%, May core inflation was at its lowest since December 2009. Indeed, retail inflation continues to be high, but the trajectory is southwards and retail core inflation has been declining faster. So it’s reasonable to expect RBI to cut rates in the second half of the year.
FOMC meet more critical
for markets than RBI
policy review
A lot will depend on what happens at the Federal Open Market Committee (FOMC) meeting on 18-19 June. Bond, equity and currency markets in Asia have witnessed a sell-off on concerns that the US Federal Reserve (Fed) may taper its so-called quantitative easing (QE) programme later this week when the FOMC, the Fed’s policymaking body, meets. There has been confusion since 22 May when Fed chairman Ben Bernanke, in answer to a question after his testimony to the joint economic committee, said: “If we see continued improvement and we have confidence that this is going to be sustained, then we could, in the next few meetings…take a step down in our pace of purchases.”
The minutes of the 1 May meeting, released on 22 May, showed that at least one voting member of the FOMC wanted the bond-buying programme to cease at its June meeting. The Fed’s monthly purchases of bonds have kept interest rates low and helped stock prices rise. Like all good things, it will come to an end one day, but the move is expected to be gradual, in sync with the US economic recovery. Bernanke’s press conference on 19 June is expected to clear up the confusion that has enveloped the markets globally and strengthened the dollar against most currencies.
RBI will keep a close tab on the FOMC meeting. What RBI will do in its July policy will depend on what Bernanke says on 19 June, how the rupee behaves after that, and the course of the monsoon. If Bernanke makes it clear that the unwinding of bond buying will be slow and gradual, the rupee stabilizes in its current range against the dollar, and the monsoon is normal, one can expect a rate cut in July. And maybe another round later. India cannot have a 7.25% policy rate when wholesale inflation is less than 5%, with no signs of growth gaining momentum

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