ADVERTISEMENT

Monetary Policy: How Low Can Rates Go?

After bringing the repo rate to 5% by December, there could still be room for more cuts of 60 bps in 2020, writes Radhika Rao.

Water flows down the Nohsngithiang Falls in Cherrapunji. (Photographer: Sanjit Das/Bloomberg)
Water flows down the Nohsngithiang Falls in Cherrapunji. (Photographer: Sanjit Das/Bloomberg)

The Reserve Bank of India has front-run regional central banks with cumulative cuts of 110 basis points in the repo rate in 2019. A favourable inflation profile and weakness in growth indicators necessitated an accommodative policy stance. With the policy rate now at the lowest since 2010, questions arise on how low it can go.

The RBI Monetary Policy Committee meets this week to decide on rates. The April-June GDP growth numbers that were released after the August rate decision disappointed as the actual outcome undershot official projections by around 80 basis points. This is likely to lead to a downward revision in the central bank’s official GDP projections, which pegged full-year growth at 6.9 percent (versus the market at 5.8-6.5 percent).

Inflation has stayed below target. The sharp cut in corporate tax rates, while positive for growth, has increased fiscal slippage risks at the margin. Of the 40 basis points cut we expect this quarter, half is likely this week. There is a significant variation in market estimates, from 5 percent to 5.15 percent.

Such a cut will reflect RBI’s decision to take the middle path – be growth-oriented with an accommodative stance, but also reserve some firepower as fiscal purse strings are loosened concurrently. A dovish bias will also help undo the rise in bond yields that was witnessed after the tax cuts, particularly at the short end of the curve. We expect a similar-sized cut in December, which would take the repo rate to 5 percent by end-2019.

A decision by the MPC this week to instead front-load the cumulative 40-basis point cut will not surprise either.
Opinion
India’s Central Bank Chief Sees Room for Rate Cut

Where To From Here?

Assuming our rate call for October-December plays out, the repo rate will stand at 5 percent by end-2019. On the basis of a few assumptions, let’s gauge how far we are from levels considered as a ‘terminal rate’. We use the Taylor Rule to estimate the approximate room for further cuts, factoring the prevailing and one-year forward growth and inflation levels. These calculations are sensitive to the assumption of the real interest rate, which will be a constant variable.

In the past, Indian policymakers maintained high real interest rates to ensure financial stability and benefit savers. However, this is being questioned after the slide in the savings rate in the past 5-6 years. Studies have suggested that real incomes, rather than interest rates, have been a more important driver for higher savings. With insufficient clarity on the RBI’s preferred real interest rate gauge, we assume the lower end of the previously suggested range of 1.25-1.75 percent (i.e. 1.25 percent) as the desired real interest rate level.

Working out four scenarios of sub/above-target inflation and varying growth trajectories, one year forward from December 2019, reveals that there is still room for more cuts of up to 60 basis points in 2020.

Of these, the base case is for growth to gradually shift back toward 6 percent in the second half of FY20 (helped also by base effects). Our forecast for sub-target inflation over the time horizon reflects a few months of inflation over 4 percent, which will then head downward going into FY21 as base effects turn favourable again. We will watch the RBI MPC’s leaning closely to review the current forecast of the repo rate at 5 percent by December 2019.

Apart from purely macro assumptions, the government’s fiscal stance (to a greater extent) and global developments (at the margin) will also influence the central bank’s policy path. In recent weeks, the government has warmed up to a fiscal stimulus, with an eye on spurring investments and industrial growth. If this persists and the stimulus steers clear of directly boosting consumption, we expect the RBI to cut rates, albeit gradually.

However, a clear shift towards a consumption stimulus might put the RBI on the defensive.
Opinion
A $20 Billion Tax Cut May Undermine Rate Reductions in India

Liquidity And Fiscal Management

The RBI’s draft report on liquidity management stuck to script, disappointing expectations that cash conditions will complement the monetary policy stance. With a shift to a surplus balance hinging on financial conditions, we suspect that the prevailing environment will be considered tight given the sticky borrowing costs for non-banks and other credit-deficient segments. This suggests that liquidity will stay flush until seasonal factors cause temporary swings and head back towards the neutral mark.

Short-term wariness was allayed as the H2FY20 borrowing plan was maintained at 38 percent of the full-year target. The monthly fiscal math will be watched for direct and indirect tax revenue trends. These will become clearer in October-December and dictate the need for a wider fiscal deficit. Apart from tax revenues, the math might require a renewed push towards disinvestment, other support (dividend payout, subsidy rollovers etc.) and expenditure curtailment.

Prima facie, we see risks of slippage in the FY20 fiscal deficit target to 3.5-3.6 percent of GDP, versus the budgeted 3.3 percent.

Government borrowing will continue to rely on the domestic debt markets as the maiden offshore bond issuance has been pushed to the backburner.

Beyond monetary and liquidity management, policymakers are likely to keep an eye on financial stability, amidst concerns that domestic banks might face renewed stress from their exposure in non-bank institutions adding to the impact of a slow recovery in corporate and industrial activity.

Radhika Rao is Vice President and economist, DBS Bank, Singapore.

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