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Business News/ Industry / Banking/  It’s now or never for RBI
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It’s now or never for RBI

The window for another rate cut remains ajar, but it is closing fast

The Indian economy remains sluggish, financial conditions tight, inflation benign and global financial markets well-behaved. Premium
The Indian economy remains sluggish, financial conditions tight, inflation benign and global financial markets well-behaved.

Having trimmed its key policy rate by 25 basis points (bps) twice this year, the Reserve Bank of India (RBI) has an opportunity to deliver a third, but likely final, quarter point cut in the repo rate to 7.25% at its upcoming policy review on 2 June. The near-term macro-conjuncture supports easier monetary policy, but both domestic and international conditions are likely to become much more challenging by the autumn. The window for another rate cut remains ajar, but it is closing fast.

The Indian economy remains sluggish, financial conditions unhelpfully tight, inflation benign and global financial markets well-behaved. Although the new national accounts ‘speedometer’ shows rapid gross domestic product (GDP) growth of around 7.5%, an array of other indicators suggests that domestic demand remains torpid. Monthly data suggest industrial momentum is once again stalling as manufacturing output edged lower in both February and March. Purchasing manager indices remain mired below long-term norms. Last year’s deficient monsoon has also weighed on output and incomes in the still vital agricultural sector, albeit not as greatly as initially feared. Imports are yet to show any sustained upswing. Higher frequency indicators such as passenger and freight traffic are also subdued. Above all, growth in bank credit to the commercial sector is feeble; up less than 10% over the last year and close to its global financial crisis low.

The need for additional monetary tonic therefore appears clear. RBI decided to leave its policy rate unchanged in its last policy review in early April partly due to frustrations over the lack of ‘transmission’ from its earlier 50 bps of easing into the real economy. In particular, with little recourse to wholesale financing and bad loans edging up, banks have been loath to cut lending rates in line with money market rates. In response to chiding by RBI governor Raghuram Rajan, some banks, most notably the State Bank of India, have trimmed lending rates but the magneto trouble is far from fixed. With moral suasion unlikely to carry much further weight, RBI faces a tacit choice: admit to impotence or try harder to spark transmission and loosen conditions at the margin.

Low inflation certainly leaves the second option on the table for the time being. Consumer Price Index (CPI) inflation slipped back to 5% in April as food inflation and housing cost inflation in particular both pulled back. Thanks to industrial spare capacity and sharp falls in industrial commodities over the last year, wholesale prices remain in deflation. But a number of darker inflationary clouds are starting to congregate on the horizon that threaten to push retail inflation back above the intermediate 6% target for early next year that RBI has set.

The looming threat of another deficient monsoon, perhaps combined with an El Niño weather phenomenon that would amplify the inflationary impact on food inflation, is the most obvious upside risk. The India Meteorological Department’s initial forecast sees a 68% chance of rainfall being below average this year. Combined with early signs of a possible rural wage inflation, the risks for food price inflation are moving to the upside.

The continued rebound in international oil prices is also threatening to re-accelerate inflation more quickly than previously hoped. The current drag on headline inflation from oil, worth over a full percentage point, will begin to reverse quickly from October. Any fall in the rupee versus the dollar will only amplify these effects. With the US Federal Reserve remaining on course to deliver its first rate hike in almost a decade perhaps as soon as September, volatility in global financial markets, especially equities, is likely to pick up, even spike, with attendant downward pressure on the rupee despite India’s limited external financing needs.

This trifecta—monsoon risks, higher global oil prices and prospectively choppier financial markets—threatens to push inflation back above RBI’s 6% target by early next year although a modal or ‘most likely’ forecast that inflation will be close to target can probably be held onto for now. The window for rate cuts, however, is clearly closing fast. It feels like now or never for RBI to deliver a third rate cut.

When combined with the prospect of limited transmission into effective borrowing costs for households and corporate entities, the temptation is to ask ‘why bother’, particularly given the need to continue to bear down on still elevated household inflation expectations?

A final swing factor may be the recent news that the centre’s budget deficit for FY2015, at 4% of GDP, against the odds, appears to have undershot its 4.1% target thanks to record bumper surplus in March. Rajan has consistently demanded faster and better quality fiscal consolidation to make space for easier monetary policy. While details on the plunge in borrowing are not yet available, finance minister Arun Jaitley can claim that he has delivered what has been asked of him and in turn expect the same from Rajan.

With critical negotiations between the central bank and North Block over the composition of the RBI’s new rate-setting Monetary Policy Committee still in train, a 25 bps rate cut could judiciously help lubricate these discussions at little potential macroeconomic cost.

The author is chief Asia economist, BNP Paribas SA.

This is the second in a series of three articles ahead of the Reserve Bank of India’s bimonthly monetary policy review on 2 June.

Respond to this column at feedback@livemint.com.

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Published: 28 May 2015, 12:30 AM IST
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