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RBI Policy: Factors That Could Swing The Decision Against A Rate Cut

While a rate cut is likely this week, room for incremental action is limited, writes Soumyajit Niyogi of India Ratings.

(Source: Bloomberg)
(Source: Bloomberg)

The Monetary Policy Committee (MPC) will decide on its future course of action this week amidst an unusual environment. The Reserve Bank of India (RBI), being the monetary policy authority of an emerging economy, is no stranger to taking decisions against the backdrop of uncertainty. But in most cases in the past, tough decisions have become necessary due to high inflation.

This time around, the RBI and the MPC, face a different predicament.

Retail inflation in India hit a series low of 1.54 percent in June with the rate of inflation falling below the minimum threshold of 2 percent specified by the government. While it is true that breach of the lower bound in one single month need not spur rate action, it is now widely believed that there has been a structural break in the inflation trajectory. If so, India could see more moderate inflation over the medium term.

However, since the current flexible inflation targeting regime is based on an institutionalized framework, ideally any action taken in times like these should be guided by a broader path for conducting monetary policy in extreme conditions.

As per the agreement signed between the government and the RBI, the central bank is tasked with maintaining inflation in a range of 2-6 percent, with the fulcrum placed at 4 percent. The decision to target a range rather than a specific number was taken to accommodate data limitations, projection errors, short-run supply gaps and instability in agriculture production since food articles have a major weight in the consumer price inflation indices. A range also allows the MPC to look-through short term shocks if it believes the economy will return to a given path over the medium term. This lends transparency and predictability to the trajectory of monetary policy in the economy.

Apart from putting in place a range, the current framework builds in the concept of a waiting/cooling period. It says that the MPC would have failed its objective only if the average inflation is more than the upper tolerance level of 6 percent or below the lower tolerance level of 2 percent for three consecutive quarters.

Going by that definition, a mere decline in CPI inflation in June to below 2 percent may not seal the case for a rate cut. If that is the case, could the RBI consider holding rates steady even though a majority of market participants are expecting a 25 basis point cut in the repo rate?

Let us consider some factors that could go against the consensus view of a rate cut.

Factor 1: Will A Rate Cut Help?

Average industrial capacity utilization levels remain much lower than the available capacity. While there has been some improvement in net global trade and the domestic outlook for demand, the needle is unlikely to move in a meaningful way. Moreover, the stressed banking sector is not in a position to support any large demand for credit, even if it were to emerge.

On this point, the MPC made an important observation at the time of the last policy review: “the current state of the economy underscores the need to revive private investment, restore banking sector health and remove infrastructural bottlenecks. Monetary policy can play a more effective role only when these factors are in place. Premature action at this stage risks disruptive policy reversals later and the loss of credibility”.

At the time of the last policy, the RBI also announced macro prudential measures to spur growth by reducing the risk weight for housing loans. By doing so, the RBI is targeting a segment where scope for transmission is high. It is also important to note that maintaining excess systemic liquidity is another thoughtful enabler by the RBI.

Overall, the RBI’s approach resembles William Brainard’s argument of deploying multiple instruments for targeting a single objective, when in an uncertain world.

Factor 2: Where Will Inflation Settle?

Another factor worth remembering is that the MPC will make the August decision without a handle on post-GST inflation. The GST, which was implemented on July 1, has impacted prices of most items except unprocessed food products. The expectation is that GST will bring prices down over the medium to long term but a short term increase in price levels can’t be ruled out. Hence assessing the impact of GST in the current situation is a crucial factor.

India Ratings expects that the inflation print for March 2018 will be in sync with the mandate, i.e. close to 4 percent. Thus, the RBI will not breach its signed mandate of maintaining inflation in a band of 4 percent (+/- 2 percent).

Factor 3: The Bond Markets

Finally, the age-old wisdom of the prevailing interest rate being an effective tool for attracting oversees bond investors has proved right again over the last few months. Bond flows turned positive starting February after the MPC changed its stance from accommodative to neutral. Total flows crossed Rs 1 lakh crore, adding strength to the Rupee.

At a time when global rates are set to firm up, the the MPC can’t ignore the possibility of potential outflows in the face of lower domestic rates.

Limited Room For Easing

In a nutshell, while it is highly possible that the RBI will act in sync with data which suggests falling inflation and sluggish growth, it is important to remember that room for incremental action is limited. Moreover, from the perspective of macro prudential stability, ensuring stable rates would be a more nuanced approach as compared to frequent changes in the policy stance.

At end of 2013, RBI refrained from hiking rates even after a sharp spike in CPI inflation driven by vegetable prices. Raghuram Rajan, then the Governor of RBI, resorted to William C. Brainard’s arguments for justifying his action. It will be interesting to see if the RBI returns to Brainard’s path once again with this policy.

Soumyajit Niyogi is Associate Director at India Ratings & Research - a Fitch Group Company. The views expressed here are his own and do not reflect those of his organisation.

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