feeling the pulse of RBI for monetary policy actions

Excessive pressure on growth and investments to drive RBI into rate cut mode

There are good reasons for RBI to delay rate cut action when headline WPI inflation is expected to move above 8% in the immediate term (CPI into double-digit) driving the real interest rate into zero percent. It is also true that inflation could not be tamed despite hawkish monetary policy stance since March 2009. The deficit system liquidity mode and resultant operative policy rate at higher end of LAF corridor is in vogue for extended period of time. It is sensible to conclude that tight system liquidity and high cost of liquidity have not been effective to control inflationary pressures. It is also obvious that these adverse monetary conditions have caused direct impact on growth, investments and fiscal deficit while adding to supply side pressures on inflation with minimal impact on consumer demand. So, should RBI continue to pursue hawkish monetary stance as tool to control inflation? It is not that RBI has not done enough to support growth. RBI has delivered CRR cuts (not taking into account 50 bps rate cut in March 2012 when deposit rates were sharply up into double-digit) to ease pressure on liquidity to maintain deficit within their tolerance level of 1% of NDTL. The monetary action of lowering CRR when system liquidity is in deficit mode cannot be seen as effective growth supportive stance. On the other hand, RBI had concerns on policy paralysis and its adverse impact on fiscal consolidation, sovereign rating and rupee exchange rate. RBI cannot afford to stay in aggressive growth supportive stance when there will be upward pressure on interest rate from high fiscal deficit, high current account deficit, pressure on rupee and investment pull-out by foreign investors if sovereign rating is pushed to junk status.

Now, there is tangible improvement in the market sentiment and confidence; the Government has pulled all its strings to be seen in policy hyper-action and eager to address issues relating to twin deficits to get the risk of sovereign downgrade out of the radar. RBI cannot ignore this stance of the Government and stay prepared to walk in the same direction. The sharp downturn in commodity prices will help to reduce trade gap which is expected to be bridged through more than adequate flows through debt and equity capital market, thus fear of rupee depreciation is significantly diluted. The benefit from lower CRUDE oil price (and strong rupee) will reflect in fiscal deficit and inflation in due course. All these will lead to RBI’s comfort on inflation and shift its attention towards growth and investments. Therefore, the immediate need is to guide interest rates down immediately and get the system into surplus liquidity mode in due course on favourable trending in fiscal deficit and inflation.   

What is the expectation from RBI? The system deficit is over Rs.1 trillion much above RBI’s tolerance level of 1% of NDTL. There will be pressure on liquidity through rest of FY13 as RBI sucks out rupees through week-on-week auctions and tax outflows. A CRR cut of minimum 25 bps is seen as certainty now and do not rule out CRR rate of 3.5% by end of FY13 i.e., 25 bps each in 4 review meetings. But these actions will not shift the system liquidity from deficit to surplus, thus the need is to guide policy rates down to get into pro-growth stance; CRR cut without rate cut will be seen only as balanced approach. It is time for RBI to shift from balanced to pro-growth and pro-investment stance. There seems to be unanimity in expectation of 25 bps cut in CRR and policy rates and provide dovish guidance on the way forward. The other options are to deliver either 25-50 bps CRR cut without rate cut or 25-50 bps rate cut without CRR cut or maintain status-quo. It would be a disappointment in the markets (and its stake holders) if RBI does not opt to cut rates this time despite significant improvement in sentiment and confidence; sharp downturn in commodity prices post QE3 and sharp appreciation in rupee. The steps taken by the Government to attract long-term capital flows, cut unproductive fiscal consumption, ensuring flow of investment and liquidity to core sectors and the eagerness to get rating upgrade will go unrecognised if RBI does not cut policy rates. While Government is addressing on items that have direct impact on inflation, it is expected of RBI to turn monetary system supportive to growth and investments. This act of RBI will be seen as complementary with the Government to get the Indian economy out of its woes. The investors are still in wait-and-watch mode on fear of sovereign rating downgrade and its adverse impact on the Economy and asset markets and it would need joint efforts of the Government and RBI to get the investors into risk-on mode. The expectation therefore is for delivery of 25 bps cut in CRR and policy rates. There will be post-policy price stability in 10Y bond yield at 7.95-8.10% and 1Y OIS rate at 7.45-7.55%.

Moses Harding