Why RBI may cut rates
Mumbai: The Reserve Bank of India’s monetary policy committee (MPC) is likely to cut the policy rate, taking note of the sustained fall in retail inflation, when it announces its policy decision on Wednesday.
Of the 15 economists surveyed by Mint, 11 expect the central bank to cut the repo rate—the rate at which the central bank infuses liquidity in the banking system (or lends to banks)—by 25 basis points. One basis point is a hundredth of a percentage point.
Here’s why RBI may cut the rate:
Calls for a rate cut strengthened when retail inflation hit a record low in June. With the latest reading at 1.54%, the CPI (consumer price index) is below the MPC’s mandated target range of 2-6% as well as RBI’s own forecast. In fact, the CPI reading since November has been lower than the 4%, which is the medium-target of the MPC. To be sure, the fall in inflation is mainly due to food prices, mainly vegetables, and statistical base effect. However, even core inflation, which excludes food and fuel, has declined in the past two readings after remaining sticky for a while.
Savers often pay a price for a rate cut. But India’s real rates, adjusted for inflation, have remained above RBI’s own assessment range of 1.25-1.75% since October, 2016, the last time when the central bank lowered the interest rate. This shows that RBI has room to cut rates without hurting savers. There are different methods of calculating real rates. RBI uses the difference between the yield on risk-free sovereign treasury-bill and the headline CPI. Going by this formula, the real rate stands at 4.8%, the highest among India’s Asian peers. And the State Bank of India’s move to cut the savings account rate proves this.
Most economists are right in betting on a rate cut if the so-called Taylor Rule, a yardstick to gauge appropriate interest rate in the economy, is to be believed. As the chart shows, the gap between RBI’s policy rate and the rate path prescribed by the Taylor rule is the widest it has been since March 2015, when the central bank formally adopted inflation targeting. The rule, developed by Stanford University monetary economist John B. Taylor, estimates the desired level of interest rates based on the output and the inflation gap. It is a widely used benchmark; Indian policymakers, including RBI officials, have often referred to it in the past. But there a few reasons why RBI could still choose not to cut the policy rate (although this is a remote possibility as things stand).
Firstly, there are several risks to inflation. To be sure, even after accounting for the reversal of the base effect, seasonal uptick in vegetable prices and implementation of housing rent allowance (HRA) for government staff and the Goods and Services Tax, CPI is unlikely to exceed the medium-term target anytime soon. However, it is prudent wait and watch . Secondly, there is scope for banks to fully transmit the past rate cuts. As the chart shows, between December 2014 and May 2017, weighted average lending rates have come down by 138 bps, while the repo rate is down by 175 bps. Some banks have reduced loan rates in June and July but a full transmission is yet to happen. Thirdly, by RBI’s own admission, it is comfortable with a higher real interest rate.
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