RBI monetary policy: Aggressive rate cuts not likely in FY17

The Reserve Bank of India (RBI) left the benchmark rates untouched on Tuesday, with the post-policy commentary offering little by way of surprise. Apart from inflation, three factors will dictate policy over the course of the year: the alignment of fiscal and monetary policies, the need to hasten policy transmission and the need to make policy formulation more transparent. Back in 2010-11, inflation of 9-10% year-on-year necessitated high domestic rates for a prolonged period. This took a toll on growth and depressed private sector activity. RBI is wary of a replay.

Last year, even as fiscal deficits were adjusted higher, RBI lowered rates in March 2015 as an endorsement of the government’s move to rationalize subsidies and re-channel savings towards higher capital expenditure. Into FY16-17, with marginal benefits from low crude prices fading, the fiscal backdrop is more challenging. The upcoming budget requires choosing between a need to maintain capital expenditure while addressing low tax and divestment proceeds. The risk is that the deficit target is adjusted higher.

To contain the inflationary impact of an accommodative fiscal policy, RBI will need to tighten policy. RBI has long emphasised the need for fiscal and monetary policy to be aligned to ensure low inflation. Apart from proving inflationary, a miss on the deficit targets could stall improvement in the public debt-to-GDP (gross domestic product) ratio. The improvement seen in recent years could reverse as nominal GDP growth falls below the government’s borrowing costs. Public debt-to-GDP has eased in recent years, before stabilizing around 60% of GDP.

The other impediment for monetary policy is the impaired transmission of policy changes. Domestic banks have been hesitant to pass rate cuts. Money market rates, especially short-term commercial paper and corporate debt yields fell notably until 4Q15. However, tight liquidity conditions since late last year have pushed these rates back up again and put a floor beneath 10-year papers.

Until this is sorted, there will be little material impact from another 25-50 basis points of rate cuts. Some groundwork is underway in this regard. The upcoming shift to the marginal cost of funds-based lending rate from April 2016 onwards is intended to make retail rates more responsive to policy changes. While the ongoing liquidity shortage has driven market rates higher, we expect a return to normalcy beyond the March 2016 quarter as government spending kicks in.

In the meantime, regular repos and ad hoc support through open market operations will be tapped to iron out the seasonal liquidity squeeze and allow the money market rates to mirror the policy rate changes. Finally, the larger unknown is the formation of the monetary policy committee. While earlier fears over a bigger say for government representatives have receded, the formation of the panel is yet to be finalized.

The actual make-up of the committee and decision-making powers will dictate the policy outlook towards the end of the year. While these factors will influence the scale of cuts, if any, we maintain our view that an aggressive rate-cutting cycle is not on the cards this year. That was probably part of the rationale behind the central bank front-loading the bulk of the cuts last year, when low oil prices amplified the improvement in the economy’s fundamentals and the external backdrop was more favourable than this year.

Radhika Rao is economist and vice-president at DBS Bank, Singapore.