The first in a series of RBI rate cuts

CategoriesBlog

Reserve Bank of India (RBI) governor Raghuram Rajan’s Pongal gift, a quarter percentage point cut in the policy rate announced before market hours on Thursday, came as a surprise.

Everyone knew a rate cut was coming, but no one expected it to happen so soon. Most analysts expected it in RBI’s February monetary policy review, about three weeks from now, while a few had thought it would happen even later—immediately after finance minister Arun Jaitley presents the Union budget in end-February.

The December monetary policy review said “a change in monetary policy stance is likely early next year, including outside the policy review cycle”. Rajan has kept his words on both counts: The rate cut, the first reduction since May 2013, has happened in early 2015 and outside the policy review cycle.

The December policy specified two conditions for a rate cut—a continuation of the current inflation trend and changes in inflationary expectations, and encouraging fiscal developments.

After slipping to zero in November, its lowest since January 2009, India’s wholesale inflation rate came in at 0.11% in December, much lower than what most analysts had expected, and the so-called core wholesale inflation, or non-food, non-oil manufacturing inflation, dropped to 1.55%, its lowest in five years. Retail inflation accelerated in December—to 5% from 4.4% in November—but far less than what the markets had been expecting.

The consensus expectation for retail inflation in November was 5.3% on account of the so-called base effect associated with fruit and vegetable prices last year.

The trigger for the rate cut is possibly lower-than-expected retail inflation in December as RBI was waiting to see trends in inflation once the base effect normalizes. The retail inflation rate will probably inch up further in coming months, but it is expected to average between 5% and 5.5% in calendar year 2015, lower than the Indian central bank’s target of 6% retail inflation by January 2016. What is equally important is that both near-term and longer-term inflation expectations have eased to single digits for the first time since September 2009.

It is possible to make the argument that Rajan was forced to cut the rate under pressure from the government, especially because fiscal developments are not encouraging and the central government’s fiscal deficit reached nearly 99% of its full-year target in the first eight months of the year to 31 March.

This may not be the case.

The government seems to be on track to meet its fiscal deficit target of 4.1% of gross domestic product (GDP) in the current fiscal year, if the revenue and expenditure trends are anything to go by.

Between April and November, the government’s revenue collection has been Rs.5.5 trillion against a Rs.12.6 trillion target. Increase in excise duty on both petrol and diesel will augment revenue collection in the last quarter of the fiscal year, which typically sees a seasonal boost. A recent Barclays research report has pointed out that in recent years, revenue collection over the final four months of the fiscal year has been similar to that raised during the first eight months of the year.

On the expenditure front, Rs.10.7 trillion of the originally budgeted Rs.17.9 trillion has been spent in the first eight months of the current fiscal year, leaving Rs.7.2 trillion of planned spending for December-March. This is quite substantial, as the actual spending by the central government in the last four months of the past three fiscal years has been between Rs.5 trillion and Rs.5.5 trillion. It would seem that Rajan is convinced that a combination of higher revenue collection and lower spending in the last four months of the fiscal year will help the government contain the fiscal deficit.

Bond yields dropped, the rupee strengthened and stocks cheered the rate cut, as it signifies a change in RBI’s policy stance following the bottling of the inflation genie in Asia’s third-largest economy after a prolonged fight.

More importantly, this is not a one-off incident; it marks the beginning of a series of rate cuts. The December policy document said: “Once the monetary policy stance shifts, subsequent policy actions will be consistent with the changed stance.”

After this cut, the policy rate is pegged at 7.75%. By December, we may see it slipping to 7.25%, provided the government is careful about the quality of fiscal consolidation and takes steps to overcome supply constraints and assures availability of key inputs such as power, land, minerals and infrastructure.

Banks are expected to cut both deposit rates as well as loan rates sooner or later. A reduction in the cost of money will encourage borrowings by individuals as well as corporations, contain banks’ bad assets as companies will be in a better position to pay back loans, change the investment climate and boost economic growth.

Acche din seem to be around the corner.

About the author

Leave a Reply

Your email address will not be published. Required fields are marked *