As expected, the Reserve Bank of India (RBI) left the repo rate, the rate at which it lends overnight funds to commercial banks, unchanged in Monday’s mid-quarter monetary policy review. However, RBI still sprang a surprise by cutting the cash reserve ratio (CRR), or the proportion of deposits that commercial banks must maintain with the central bank, by a quarter of a percentage point. In the context of the data flow since the July policy review, the decision to keep the repo rate steady was fully justified. Although growth numbers have been disappointing, both in terms of first-quarter gross domestic product (GDP) and other high-frequency data, the downside risks to growth have abated in the last one month. First, a material improvement in monsoon rainfall has boosted the prospects of agriculture. Second, actions by the European Central Bank and the US Federal Reserve have removed tail risks for the global economy. Lastly, a spate of announcements by the government last week has improved investor sentiment and may help in staving off a rating downgrade by global credit assessors.
On the other hand, the inflation picture has worsened. Inflation as measured by the wholesale price index (WPI) moved up in August and core WPI inflation also rose from the level seen in the early part of this financial year. Worryingly, retail level inflation measures continue to be elevated. Overall, inflation continues to remain way above RBI’s comfort zone despite the weakness in domestic demand conditions. Looking ahead, there is the possibility that higher fuel prices could have an adverse effect on underlying inflation. WPI inflation could rise above 8% before hitting 7.5% by March 2013, little changed from 7.70% in March 2012. Core WPI inflation may also edge up and stay above 5.5% by March 2013 compared to 5% in March 2012. Such stickiness in inflation suggests that the trend growth rate of the economy may be much lower than the 7-7.5% estimated by RBI. Further, in the face of a prolonged period of high inflation, expectations seem to have got unhinged and RBI has a serious task in hand to put the inflation genie inside the bottle. In this environment, the RBI seems to have already done the utmost it can by cutting the repo rate by 50 basis points at the beginning of the financial year. (One basis point is 0.01 percentage point). However, expectations of further rate cuts reach fever pitch every time RBI reviews monetary policy. This time around, the logic was that RBI would respond to the steps taken by the government last week. From the RBI statement, it is clear that the central bank views the latest steps as only a payback for the April rate cut. Moreover, the RBI has also pointed out that further steps need to be taken on the fiscal front and the announced steps have to be implemented. In the interim, monetary policy can only support growth with some symbolic measures even as the central focus remains on inflation. The CRR cut can thus be seen as a token measure. This also explains the penchant of RBI to keep rolling out some measure or other in every policy since June without touching the repo rate. I think the central bank will continue with this tactic for the rest of the calendar year.
A. Prasanna is chief economist ICICI Securities Primary Dealership Ltd
