5 reasons for RBI to show restraint

Trading in interest rate swaps suggests expectations are running high from the next monetary policy meet. Some traders are expecting the monetary policy committee (MPC) to go for a deeper 50 basis points (bps) cut in the repo rate, given the concerns over growth and inflation remaining below target.

They have found support in the language of the past two policy statements, which suggested the Reserve Bank of India could opt for deeper rate cuts if growth falters.

If the central bank keeps rates unchanged on Thursday, markets would see this as pulling a fast one on them. If RBI cuts the repo rate by 25 bps, it would mean the joke is on the markets again to have hoped for a 50 bps cut. One basis point is 0.01%.

But there are multiple reasons why the six members of MPC would be better off by not voting for a 50 bps bazooka of a rate cut.

Peek-a-boo inflation

Top of the list is inflation, given that RBI is mandated to keep retail inflation in a band of 4-6%. Headline retail inflation is likely to undershoot the central bank’s 4% target until the first half of 2019-20. That said, crude oil prices are notoriously difficult to predict. Goldman Sachs analysts noted that food prices are showing signs of a bounceback. “We expect some pick-up in food inflation over the course of the year as favourable base effects begin to wane and momentum builds as indicated by the recent prints on consumer and wholesale prices,” it said in a note. Core inflation hasn’t budged and some economists believe headline inflation would move up towards core inflation. So, a 50 bps rate cut would be overkill.

Don’t get lost in transmission

What good would a 50 bps rate cut do if it takes a long time to get transmitted to the final beneficiaries, the real sector?

Fraught with shallow debt markets and a banking sector holding dud loans, transmission in India is weak. Add the love for cash among Indians and it only complicates the situation. That explains why the last rate cut in February is yet to reflect in loan and bond rates. What RBI needs to do is fix this, instead of going for higher doses of rate reductions. A 25 bps rate cut will pack a punch, if liquidity is easy enough to trickle this immediately to loan and bond rates.

Publicly easy, privately shy

Interest rates aren’t the biggest impediment to private capital expenditure, which RBI governor Shaktikanta Das indicated he is worried about. The biggest impediment is fiscal profligacy. The government’s borrowing is budgeted to be ₹7.10 trillion for FY20, a 24% rise from FY19. The risk-free bond yield curve is steep due to supply of bonds from the government. “What needs to be clear is how the government will walk the fiscal path. This would be one key factor that determines future action of RBI,” says Abheek Barua, chief economist at HDFC Bank.

More worrying is the borrowing by state enterprises. The room for private sector borrowing reduces if the government continues to corner a large share. RBI is unfortunately in a position wherein absorbing government borrowing is inevitable, if it wants to create space for private borrowers. This is a pill RBI has to swallow.

Not a heavy burden

The bright side is that fiscal stimulus is happening. Already, promises have been made for subsidies to the poor and sops for businesses. Ergo, monetary policy can ease off and give just the right amount of fillip. This brings us back to the point that 25 bps can pack enough punch to boost the economy.

Less is more

The emerging narrative on jobs shows that Indians are not confident of employment. A source of this distress is slowing growth. There is no doubt the economy needs accommodation. But as too much love can smother, too deep a rate cut could only fan inflationary pressures, which would hurt the economy sooner than later.

Mixed signals on growth and inflation are reason enough for caution on big policy responses. After all, fools rush in where angels fear to tread.