BackOpinion | RBI should not delay expected rate cut to October
The uncertainty posed by high inflation may push the MPC to deliver a dovish pause
PremiumThe August monetary policy will be a close call, as far as policy rate cut is concerned. We think the Monetary Policy Committee (MPC) should deliver a 25 basis points (bps) repo and 35bps reverse repo rate cut. However, the uncertainty posed by the current higher-than-anticipated consumer price index (CPI) print may push the MPC to deliver a dovish pause, keeping hopes alive for an October rate cut. In our view, the Reserve Bank of India (RBI) should not delay the expected rate cut to October, for the following reasons.
The current spike in CPI inflation, particularly core CPI, is due to statistical issues, as well as higher gold and local pump prices, without which, true core inflation is around 3.5% year-on-year. Meanwhile, risks to growth are rising by the day as covid-19 cases are surging in economically relevant states such as Maharashtra, Tamil Nadu, Gujarat and Karnataka (together contributing 40% to national gross domestic product). We expect real GDP to contract 6.2% y-o-y in FY21 under our baseline scenario, but if localized lockdowns are broad-based and extended, we see risks of growth declining by more than 8% y-o-y under our worse-case scenario.
Given the expected growth-inflation trajectory, the absence of meaningful fiscal space to support growth and the lag with which monetary transmission works, it is not advisable to delay any rate cut to October, particularly as it will be very close to the US presidential election, which may coincide with greater financial market volatility. It is not as if the inflation trajectory will be altered significantly depending on whether the MPC cuts rates in August or not. If that were the case and RBI decided to pause in August, then the central bank should not cut rates even in the subsequent meetings.
But a pre-emptive rate cut can be helpful for other reasons. The six-month loan moratorium period is coming to an end in August and it is unlikely that there will be a blanket extension, given moral hazard risks. In the backdrop of this looming “moratorium cliff", it will help if RBI at least reduces the repo rate by 25bps, so that banks in turn reduce the lending rate further and faster, thereby making it easier for individuals and sectors not eligible for moratorium relief to be able to service their debt obligations. The benefit of a front-loaded rate cut is significantly higher in the backdrop of elevated financial stability risks and a worrying non-performing assets (NPA) outlook, in our view, as against any structural risk to inflation, which we forecast to fall below 3% by end-December.
Even a dovish pause can push up term-premium, lead to tightening of financial conditions, increase financial stability risks and force RBI’s hand to eventually announce more Operation Twist and open market operation (OMO) purchases to reverse the potential negative trend. Consequently, “doing nothing" is not an option for the central bank, as the repercussions of such a move will likely be a net-negative for the economy, in our view. In case the MPC decides to keep the repo rate steady, then RBI could consider delivering some indirect form of easing, which could include i) a 25-35bps cut in reverse repo rate; ii) an introduction of Standing Deposit Facility below the reverse repo rate; iii) an announcement of longer tenor LTROs; iv) or an increase in “hold to maturity" (HTM) limit of bonds.
On the regulatory side, we expect an extension of the loan moratorium by another three months for only severely stressed sectors and the announcement of a one-time loan restructuring to give a breather to banks to deal with pipeline NPA risks.
Kaushik Das is India Chief Economist, Deutsche Bank.
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