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Posted by: Deepa Vasudevan on Tue, Feb 12th, 2019

Monetary Policy: The Surprising Rate Cut

Last week’s 25 basis points cut in the policy repo rate was a bit of a surprise, though the change in monetary stance from “calibrated tightening” to “neutral” was widely expected. The real surprise was that RBI’s monetary easing followed the fiscal expansion proposed by the Interim budget. It has been many years since the Indian economy has been pampered with a fiscal and monetary easing at the same time. Naturally, there are concerns about whether it is necessary and/or viable at this point.

It must be accepted that the rate cut did not go against RBI’s inflation targeting mandate. Between April and December 2018, headline CPI inflation averaged 3.8%, and is forecast to be 3.2%-3.4% in H1FY20; well below the targeted 4% to 6% range. Upside risks to inflation seem to be receding- crude prices are volatile but there are no immediate geopolitical risks to crude; and food prices remain benign especially with the likelihood of a normal monsoon. There remains the problem of sticky education and health prices- but RBI has chosen to view them as temporary spikes. Inflation expectations- as reported by RBI’s quarterly inflation expectations survey- shows a moderation in the 3-month ahead period. As a result, real interest rates have risen throughout 2018 (Pic 1).

 

Pic 1: Real Interest Rates 

Source: RBI

RBI is not alone in moving towards a monetary easing. The US Fed has recently adopted a dovish stance, as have Central Banks in England and Australia. But each economy has unique characteristics and responds differently to monetary easing. In the case of India, two questions come up whenever an easing cycle is started. First, does economic growth at this stage warrant a monetary easing? Second, will the rate cut be transmitted by banks as lower lending rates?

The growth question is easily addressed. The economy has recovered from the twin setbacks of demonetization and GST implementation, and GDP growth has inched back towards its potential level of 7%-7.5%. High frequency indicators such as improved bank credit, rising capacity utilization, and PMI in the expansion zone suggest a growth recovery. Although consumption and government spending have been the chief drivers of demand in India post-2008, some improvement in investments and exports was seen in Q2FY19 (Pic 2).  The measures proposed in this RBI policy to ease funding to the NBFC sector, along with the rate cut, may spur investment and support export, thus making growth more broad-based across demand components.

 

 Pic 2: Components of Demand

Source: CSO

The main problem is that banks may not be keen to cut lending rates. Gross Non-Performing Assets of banks are declining but still relatively high (10.8% of total assets in Sept 2018). The need to make provisions for stressed assets discourages banks from aggressively growing their loan portfolio. Banks face other constraints on interest rates.  Growth in bank deposits has declined in the last three years as households shifted to relatively more lucrative investment avenues such as mutual funds. However, with a pick-up in bank lending, the credit-deposit ratio of banks is forecast to reach 78% by March 2019. A CRISIL study estimates that banks will need to raise Rs.20 trillion through fresh deposits to maintain this pace of lending, and therefore have limited scope to cut deposit rates[1]. As deposits form the bulk of bank funding, banks (especially public sector banks) are unlikely to cut deposit rates. Without a cut in deposit rates, it is not clear how banks will be able to reduce lending rates in a significant way. And without that, monetary easing may not translate into lower household EMIs and cheaper corporate borrowing.

Factors beyond the control of RBI, such as the trade war or election-related political uncertainty will also impact economic conditions; and these could derail the policy stance quite easily. For example, if the rupee was to depreciate steeply and suddenly as a result of an unstable coalition coming to power in May 2019, RBI may be forced to tighten interest rates to stem capital outflows and manage exchange rate volatility. At this point, therefore, it is tough to predict the impact of the monetary easing. Markets are aware of these uncertainties: after the policy announcement, the sovereign yield curve steepened. Yields at the shorter end declined by 15-18 bps, while the benchmark 10-yr lost less than 5 bps; suggesting that markets are happy with lower short-term rates, but expect higher government borrowing to push up long term rates. A combination of easy monetary policy and easy fiscal policy has to be supported by a strong growth in incomes, growth and government revenues, and it is not certain that India can deliver that in the face of various global and domestic uncertainties.

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[1] CRISIL Ratings Press Release, February 6, 2019, Mumbai

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