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Posted by: Deepa Vasudevan on Fri, Jan 16th, 2015

The RBI rate cut: A Signal of Support

The RBI cut its key policy rate- the repo rate - by 25 basis points today- in an unexpected off-policy date announcement. This marks the end of the interest tightening cycle that started in September 2013 in response to the rupee crisis. The quantum of the rate cut is small- probably not enough to kick off the much-awaited investment revival. But its importance lies in the signal that RBI is giving: that it is now ready to support demand by lowering the cost of credit and investment. 

 

What prompted this sudden drop in rates? A comparison of inflation and economic growth gives us some answers (See Pic below).

 

Pic 1 Inflation and Manufacturing Growth

Inflation and Manufacturing Growth

Source: CSO

 

 

Inflation, both wholesale and retail, has fallen steadily over the last year. WPI inflation is now around 0%, and CPI inflation- at 5%- is well below the 8% target set for January 2015. Several factors have contributed to the fall in prices: declining international prices of crude, efficient supply-side management of cereals by the government, and fall in the prices of many commodities. On the other hand, economic demand is poor.  Barring a few short-lived spikes, growth in the Index of Industrial Production for the Manufacturing Sector (IIP) has stayed below 5%, and has often turned negative, despite favourable inflation. Other macro-economic indicators are stable for the moment: the current account deficit is expected to be within 2% of GDP, the government appears to be committed to fiscal prudence, and foreign capital inflows are robust. The only variable not in sync is economic growth!

 

At last, RBI faces the sort of inflation-growth trade-off that Indian industry has been waiting for. With benign inflation, and no immediate threats to prices in sight, the recommended policy action would be to cut rates to stimulate investment and consumption demand. RBI has done that, in a small way. The token cut is a sign that inflation has been brought under control. It is also a signal that if the government is prepared to manage fiscal policy sensibly, then RBI will do its bit to support growth through monetary policy. 

Ajit Purohit on Tue, Jan 20th, 2015 4:56:25 pm

If the next rate cut comes in March then there will be a significant time for the market to go up further.

Atul Kamdar on Sat, Jan 17th, 2015 5:08:34 pm

A 25 bps cut in repo rate is just the beginning. We can definitely another 25 bps cut in Feb credit policy announcements. But, the markets may not react the same way then as they reacted now. This time, the unexpected euphoria was there. Next cut is may be already anticipated.

Neha Tewari on Fri, Jan 16th, 2015 5:22:45 pm

A 25bps cut is too small to create a significant impact. Would'nt it have been prudent to go in for a 50 bps cut in Feb (before or after budget)? Or maybe the underlying signal is that they will cut another 25 bps in a month's time around the budget ?

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