strong case for 50 bps rate cut on 15th March policy review

Attention on rate cut action to address cost of liquidity

RBI has done its best to address the structural imbalance in system liquidity. It is expected that deficit system liquidity will be close to RBI’s comfort level of 1% of NDTL on shift into FY13. The factors concerning the RBI at this stage will be high cost of liquidity and its impact on growth momentum. The IIP number for January 2012 exhibiting growth rate of 6.8% driven by 42.1% growth in consumer non-durables (as against average 7% for April-December 2011) will not emerge as strong factor to delay rate cut action. Despite the IIP and WPI prints for rest of FY12, the outlook for FY13 is clear. There are strong headwinds to growth momentum to drive GDP growth rate below 7% while there is good comfort on headline inflation to continue its downtrend into 6% by end of FY13. There is immediate need for RBI to shift into aggressive growth supportive stance to address issues arising from fiscal and trade deficit. The need therefore is for RBI to turn its focus away from CRR cuts to trigger rate cut actions. The expectation from market stake holders is unanimous but opinions are different on its timing; whether on 15^th March or end of April 2012. If the decision is to deliver rate cut; it is better to deliver it soon to cut short the lag time of transmission.

The benefit of delivery of rate cut sooner than later will be good for money markets to end the financial year FY12 in a positive tone. The overnight rate is already trading at 40-50 bps over the operative policy rate of 8.5% and 0.5% downward shift in policy rate (with overnight rate at 8.40-8.50%) may not be viewed as pro-inflation but will be good for policy transmission into lending rates. It is important to drive the term money rate curve of 6-12 months tenor below Banks’ Base Rate to enable Banks to cut lending rates. It is also important to bring stability in the mid to longer end of sovereign bond yield curve. The 10Y bond yield is under pressure trading at higher end of short term range of 8.10-8.35%. The fear in the minds of investors is that of closure of OMO counter on aggressive liquidity injection through CRR cuts. The supply of bonds in FY13 is expected to be at Rs.5.0-5.5 Trillion with excess SLR holding of 4-5% of NDTL by Banks. The concerns from supply side will continue to stay valid to exert upward pressure on bond yields. RBI would need to remove the build up of bearish set up quickly through start of rate reversal cycle. It would help to provide stability in 10Y bond yield at 8.0-8.20% considered good to cut interest expenses of the Government.

The expectation therefore is for shift of LAF corridor from current 7.5-8.5% to 7.0-8.0%. RBI is expected to maintain operative policy rate at higher end of LAF corridor with deficit system liquidity at 1% of NDTL till clarity emerges on trending in growth momentum and headline inflation. The confirmation of uptrend in growth and downtrend in inflation would then trigger next rounds of CRR cut to drive the operative policy rate from 8.0% to 7.0%; thereby achieving the 150 bps rate cut (from 8.5% to 7.0%) by maintaining CRR pre-emption around 3.5%. This would be a win-win strategy for all stake holders of the economy.  The advantage in this stance is the availability of flexibility in taking a quick reversal in monetary policy stance if things do not turn out as per expectation on growth and inflation. RBI has demonstrated its proactive behaviour through delivery of CRR cuts earlier than schedule and it is fair to expect delivery of rate cut without delay given the immediate need to address high cost of liquidity.

Moses Harding