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Business News/ Market / Mark-to-market/  Reasons for RBI’s rate cut
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Reasons for RBI’s rate cut

The key data points that prompted Rajan to cut rates are rebased consumer price inflation rate for January and the budget

RBI governor Raghuram Rajan likes to surprise the market, probably because surprises get him more bang for the buck. Photo: Abhijit Bhatlekar/Mint (Abhijit Bhatlekar/Mint)Premium
RBI governor Raghuram Rajan likes to surprise the market, probably because surprises get him more bang for the buck. Photo: Abhijit Bhatlekar/Mint
(Abhijit Bhatlekar/Mint)

Everybody knew a rate cut was on the cards; the surprise lies in the out-of-turn cut well in advance of the next policy meeting. One reason governor Raghuram Rajan gives is: “With the release of the agreement on the monetary policy framework, it is appropriate for the Reserve Bank to offer guidance on how it will implement the mandate."

The mandate is to “primarily maintain price stability while keeping in mind the objective of growth" as well as the inflation targets of less than 6% by January next year and 4% with a range of +/- 2 percentage points thereafter. With the rate cut, Rajan is signalling that 1) the inflation target for 6% is going to be easily achieved and 2) he doesn’t believe in the rosy new gross domestic product (GDP) growth rates put out by the Central Statistics Office; he believes the economy is still weak and so he’s doing his bit to support growth. Moreover, banks haven’t really reacted to the Reserve Bank of India’s (RBI’s) last rate cut, so this is another nudge to them to lower lending rates.

Rajan is saying if he’s convinced growth can do with a helping hand without igniting inflationary pressures, then he’ll do what he can without sticking to the time-table of monetary policy meetings. He also likes to surprise the market, probably because surprises get him more bang for the buck. A 25 basis point rate cut, after all, is no big deal—the surprise and its impact on sentiment is worth much more. One basis point is one-hundredth of a percentage point.

The data points that prompted Rajan to cut rates are 1) the rebased consumer price inflation rate for January, which came in lower than expected and 2) the Union budget, which he says has relatively realistic projections and attempts to ease supply-side pressures.

Rajan also thinks that states may use the extra resources they now have to reduce their deficits; so, the overall deficit figure for the country may be lower. The rate cut could also be RBI’s way of reciprocating the government’s acceptance of the monetary policy framework, which strengthens RBI’s hands.

Finally, there’s the international factor. Since RBI policy rate cut on 15 January, the central banks of China, Indonesia, Turkey, Australia, Russia, Pakistan and Egypt have all cut their policy rates. Several central banks in Europe have pushed their rates below zero. The European Central Bank is going in for quantitative easing. In a recent speech, Rajan spoke of an avalanche of capital flows to India as other central banks cut rates. He said, “We have got an avalanche of capital inflows. Our problem is, we also have high inflation; so, we cannot cut interest rates to the bone in order to tell those countries—don’t come here expecting high interest rates." The inflows have buoyed the rupee, making it dearer compared with its peers, which is bad for exporters. RBI, however, points to the disinflationary effect of a stronger rupee as yet another reason for the rate cut.

With two rate cuts of 25 basis points each in two months, the markets are clearly hoping for more. How much leeway is there for more rate cuts? Rajan has said he aims for a real interest rate of 1.5-2%. With inflation at 5.1% and with the repo rate at 7.5%, the real policy rate is currently 2.4%; so, more cuts should follow. But the RBI statement says, “Softer readings on inflation are expected to come in through the first half of 2015-16 before firming up to below 6% in the second half." That suggests it doesn’t expect too much of a fall in rates in future.

A. Prasanna, chief economist at ICICI Securities Primary Dealership, thinks another 25 basis point rate cut is on the cards, but after that, it will depend on the inflation trajectory. Moreover, Rajan also says RBI will aim at bringing down inflation “to 4% by the end of a two-year period starting fiscal year 2016-17." As Gaurav Kapur, senior economist at RBS, points out, that could limit the scope for rate cuts, unless of course inflation continues to surprise us pleasantly.

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Published: 04 Mar 2015, 12:45 PM IST
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