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Posted by: Deepa Vasudevan on Wed, Apr 3rd, 2019

Will RBI cut Rates this Week?

The Reserve Bank of India juggles many roles. Primarily, it is supposed to keep consumer price inflation under control (between 2% and 6%). In addition, it manages the debt of the Government of India. It regulates the banking system. It implements monetary policy decisions taken by the MPC, and ensures durable liquidity in the system. It intervenes, if necessary, to manage exchange rate volatility. It is implicitly understood that RBI will act to support economic growth when possible, though there is no official mandate to this effect.

RBI’s multiple roles create conflicting objectives. Industry wants low interest rates. Their argument is that with inflation predicted to stay below 4% until December 2019, present real lending rates are too high, and need a policy push downwards (See Picture below).

RBI’s multiple roles create conflicting objectives. Industry wants low interest rates. Their argument is that with inflation predicted to stay below 4% until December 2019, present real lending rates are too high, and need a policy push downwards (See Pic below).

 Pic 1: Real Interest Rates

 

Households want high deposit rates but low lending rates; banks want exactly the opposite. The government wants lower interest rates to keep voters happy and to cut down interest expenses (which account for a quarter of government spending). As the manager of government debt, RBI should aim to reduce rates. As an inflation-targeting bank, it should not, out of concern for incipient price pressures from monsoon uncertainty, rising core inflation and the impact of election related spending. As a banking regulator, RBI knows that a sharp cut in interest rates is more likely to be transmitted through the banking system. As a liquidity manager, it is aware that falling interest rates will push household savings away from bank deposits into mutual funds or real estate. So what should RBI do? As we approach the first monetary policy review for FY20, what objective should be given priority in framing policy?

One way to resolve this conflict is to simply focus on the most pressing need. Right now, inflation does not appear to be as big a threat as slowing growth. Given the strong growth in bank credit and low fuel prices, a rate cut is likely to stimulate the economy. It is this belief that has built up market expectations of monetary easing ahead of the April monetary policy meet. A 25 basis point cut is being widely anticipated; and some are even hoping for a 50 basis point cut to front end the entire easing for the year.

Alternately, RBI may opt to wait for additional data. The first monsoon predictions by IMD are usually announced in April. Systemic liquidity is certain to improve when the second dollar-rupee swap is conducted in April; in any case, liquidity conditions will ease as government departments start spending in the new fiscal year. The outcome of elections will be known by May 2019, after which there will be more information about the new government’s fiscal policies. By the next monetary policy meet in June, there should be more clarity about the direction of growth and inflation. So RBI could choose to pause rates, while working towards improving transmission and strengthening bank balance sheets.

Whatever decision is made this week, it will be the outcome of optimizing as many objectives as possible under the present circumstances, and should be viewed in that context. To quote the Governor, Mr. Shaktikanta Das: “…The challenge is to try and read the situation and take decisive steps in pursuit of multiple responsibilities.”

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