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Opinion | The focus shifts to the transmission of rate cuts

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Rajni Thakur

In its first Monetary Policy Statement for the financial year 2019-20, the Reserve Bank of India has cut the repo rate by 25 basis points to 6 percent. The second consecutive rate cut announced today was widely expected given the softer macro backdrop, lower than targeted inflation level in the economy. And, it is a clear policy bend to support growth.

With a subdued growth outlook and a few tepid data points recently, the case for a rate cut support to boost growth naturally gets stronger. Given the continued downside surprises in CPI, broadly anchored commodity prices, and a benign global monetary policy backdrop, the space for a rate cut was open as well. What did, however, surprise the market was that the MPC decided to retain its “neutral” policy stance even while announcing the second consecutive rate cut.

The bond market had set its expectations on a deeper cut while the RBI decided to be more cautious than the market. The tone and message of the statement did indicate a bias, at least in the near term, towards a growth supportive stance. A calibrated approach, however, gives the central bank just the elbow room it needs to continue with its data dependency and alter rate path in response to evolving macro dynamics, particularly at a time when the forward path for both growth and inflation remains muddled.

The RBI has revised down its inflation forecasts for the year, with risks broadly balanced around the central trajectory. For FY 2019-20, the H1 inflation expectation was revised down by 30 basis points (bps) to 3 percent while the H2 inflation is now projected at 3.7 percent, taking the RBI’s full year FY20 inflation forecast to 3.3 percent, well under the 4 percent target. Growth projections have been scaled down as well. The FY20 full-year GDP growth is now projected to grow at 7.2 percent, versus 7.4 percent previously.

“The output gap remains negative and the domestic economy is facing headwinds, especially on the global front. The need is to strengthen domestic growth impulses by spurring private investment which has remained sluggish,” the statement notes.

The benign inflation expectations and a struggling growth scenario that MPC has outlined indicate a largely dovish tone and further rate cuts in the year. At this point, however, the RBI seems to be more focused on the efficacy of the rate cut and its transmission to the end borrowers. There is a clear message in MPC’s post-policy interactions that, for now, it is more important to push for greater transmission of the rate cut. Otherwise, it becomes a redundant rate reduction.

With savings growth in the economy coming down sharply and banks competing to attract depositors, lowering deposit rates seems difficult for banks at the current juncture and, in that case, the room for any material cut in lending rates remains tight.

For a smoother transmission of policy rates in the economy at this point, liquidity is the key. Liquidity management has suffered owing to pressures from various factors including, demonetisation, BoP deficit and the demand for currency ahead of elections etc. Till the time the deposits growth picks up materially, the liquidity induction will need to step up to match the deficit for the rate cut to be effective.

There are already signs of focus shifting to liquidity management with the aggressive open market operations and a new swap window opened by the RBI. With the Central Bank more focused on the efficacy of rate cut and its transmission to the end borrowers, we expect to see more action on the liquidity front than rates in the current cycle.

Rajni Thakur is an economist at RBL Bank

 

 



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