Eight weeks ago, the monetary policy committee (MPC) had unanimously voted to keep the Reserve Bank of India’s (RBI’s) policy rates unchanged, much to the chagrin of the market.
Going by the arguments now, it seems that the time is ripe for a 25 basis points cut in policy rates. But before jumping to conclusions, a look at the reasons why MPC voted for a pause last time is necessary. MPC had listed stubborn core inflation, transitory effects of demonetisation, rising global crude oil prices, absence of hard data on demonetisation and lack of transmission by banks as reasons for keeping rates on hold.
Of these, the first three haven’t changed since then. The first reason and the bedrock of monetary policy is inflation. Indeed, the retail headline inflation has pleasantly continued to slide and there is no doubt that demonetisation has made the fall to 3.41% in December faster. Even if this downward momentum slows, inflation is likely to be far slower than the 5% target for March.
In the previous policy meeting, even the most dovish member had flagged off the sticky core inflation as a reason to avoid a rate cut. Core inflation is still sticky and once the seasonal fall in vegetable prices wears off, the headline inflation will begin to reflect the resilience of the core. The other growing threat to inflation is from rising global crude oil prices. Imported inflation is already making its presence felt and this would only increase the pressure going forward. Oil prices have risen by more than 5% since MPC’s previous meet.
The second reason given by MPC was that the effects of demonetisation are transitory. This argument still holds and fresh data points suggest that the purging of 86% of cash slowed but didn’t destroy the wheels of growth.
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What has indeed materialized is the transmission by banks, as lenders have lowered their lending rates by almost 90 basis points over the last two months. The liquidity deluge brought about by demonetisation has for all practical purposes made the reverse repo rate of 5.75% the effective policy rate instead of 6.25% repo rate. An enduring liquidity surplus will go a long way into bringing lending rates down rather than a piecemeal 25 basis point cut in policy rates as a signal.
An additional element that MPC had waited for was the Union budget. The fiscal math will effortlessly fit into the central bank’s calculations on inflation and growth. With no surprises here, the budget doesn’t sway the needle either way for a rate move.
If the MPC members stand by their previous assessment of economic conditions, then a rate cut now will be a wasted effort. Leaving the liquidity alone will buy RBI more time to ponder on rate cuts.