Monetary Policy: Why There’s Room For Another Rate Cut

Acting along expected lines, the Monetary Policy Committee reduced the repo rate by 25 basis points to 5.75 percent – the lowest level in the inflation targeting regime was put in place in 2016. The decision to cut the rate was unanimous and was the third successive 25 basis points cut. The decision to change the forward guidance—policy stance—to “accommodative” from “neutral”, which signalled more monetary easing ahead to support growth, was also unanimous.

Such unanimity among the MPC members, is a clear indication that the concerns on the growth slowdown outweigh any risks to the inflation target, over the first half of the year at least. The policy statement, in fact, noted that a sharp slowdown in investment activity with a continuing moderation in private consumption is a matter of concern.

The RBI forecasts for inflation and real GDP growth, underpinning these decisions, were revised lower compared with their April level. As per the revised trajectory, CPI inflation is expected to remain below 4 percent throughout the current financial year, with headline inflation seen in the range of 3-3.1 percent in the first half and 3.4-3.7 percent in the second half. The risks to this inflation trajectory are seen as evenly balanced—neither upside nor downside risks are dominant. Real GDP growth is seen a tad lower, too, at 7 percent during financial year 2020 compared with the April projection of 7.2 percent with first half growth seen between 6.4-6.7 percent and second half growth seen in the range of 7.2-7.5 percent. And, the risks to this forecast are evenly balanced too.

Any further monetary easing beyond that would depend upon on growth under performing and/or inflation undershooting the forecasts. The extent of fiscal policy stimulus to support consumption and investment, would also be critical in determining the space for easing.

On the growth front, the current cyclical slowdown can prolong into the second half if private consumption growth remains muted. A key risk which feeds into that is the credit squeeze from the non-banking financial sector becoming more acute. The external sector, too, could add to the growth drag, if export growth weakens sharply due to slower global growth. The slowdown in investment activity is, however, likely to prove short-lived, as with the new government in place, public capex spending is likely to pick up.

On the inflation front, the key negative risk is from a severe monsoon shortfall, which could arrest the broad-based food dis-inflation seen over the last couple of years. Otherwise, core inflation, after the rapid softening seen since October last year, is likely to stabilise around 4 percent. The policy statement notes that the sharp decline in core inflation due to weak demand has imparted a downward bias to the inflation trajectory for the year. Moreover, the recent easing in oil prices, is yet to see a complete pass through.

Thus, the headline inflation on average is expected to be around 3.3 percent-3.5 percent, strengthening the case for more monetary easing going forward.

Liquidity Management Framework

In another significant development, the RBI announced that an internal working group is reviewing its liquidity management framework to simplify it and improve communication around its objectives. The core objective of this framework is to ensure that the weighted average call rate is closely aligned to the repo rate. In pursuit of that, the central bank uses a variety of instruments to manage liquidity—Liquidity Adjustment Facility (LAF), when there are frictional imbalances caused by changes in the government cash balances and other short-term factors; and open market operations, when there are durable mismatches in the system due to capital flow volatility and changes in currency in circulation.

The banking system is usually in deficit mode, with the RBI injecting liquidity through its LAF operations, if the shortage is frictional, and through open market operations, if the shortage is durable in nature.

In order to improve communication around this framework, the working group may choose to provide a rule-based measure of adequate level of liquidity, benchmarked to the banks’ net demand and time liabilities (NDTL). That would provide forward-looking guidance on evolution of liquidity conditions. It would also facilitate monetary transmission to lending and market rates, as that too among other things, depends on the current level and future assessment of liquidity conditions.

A faster transmission of the lower repo rate to broader rates in the economy would, among other things, require that systemic liquidity remains in the easier zone, as has been seen since early June, than the persistently large level of deficit, seen since the third quarter of last fiscal year.

On the issue otherwise, the RBI governor in his post policy conference reassured that the central bank will provide adequate liquidity for productive purposes.

In summary, the monetary policy will continue to provide stimulus through lower policy rates, the transmission of which to market and lending rates would happen with a lag of 6-9 months and help boost investments and consumption.

There is space for another 25-50 basis points more of easing, with average inflation seen well below 4 percent throughout the current fiscal and growth expected to remain below potential in the first half at least. The extent of fiscal stimulus to support growth, would also be critical in determining the overall space of easing, as higher fiscal deficits for centre and states could reduce the headroom and need for any significant easing.

Gaurav Kapur is the chief economist of IndusInd Bank. Views are personal.

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