Cutting it fine

Government’s prudence in staying with fiscal rectitude has made room for the RBI to cut policy rates.

By: Express News Service | Updated: April 6, 2016 12:06 am
Reserve bank of india, RBI, repo rate Reserve Bank of India

In its last monetary policy review on February 2, the RBI, which seems to be under constant pressure to cut interest rates, chose to kick the can down the road. But it did so after laying down the two conditions that must be met before it could consider cutting rates again. The first, that inflation should show a downward trend. The second requirement was that the government should undertake “structural reforms”. On Tuesday, the RBI cut the repo rate — the rate at which it loans funds to the banking system — by 25 basis points. Evidently, the RBI is satisfied with the movement on both the conditions it had laid down. In 2015, the RBI cut 125 basis points but only 60 of those were transmitted by the banks to the market. The challenge now is to ensure effective transmission — not just of this cut but also of those that preceded it.

After rising for six consecutive months, retail inflation “dropped sharply” in February, largely due to an unanticipated fall in the prices of pulses and vegetables. RBI surveys have also shown that household inflation expectations have come down to single digits. There will be some pressure on prices once the Seventh Pay Commission and OROP awards come through, but for the time being, the RBI does not find a reason to worry. The other reassuring signal is the movement in the government’s reforms agenda. The government has stuck to fiscal rectitude, which in turn eases future inflationary pressures. The RBI has also commended the government on the focus of the budget: “The government has also set out a comprehensive strategy for reinvigorating demand in the rural economy, enhancing the economy’s social and physical infrastructure, and improving the environment for doing business and deepening institutional reform”.

The RBI has pointed towards better transmission of cuts, even as Governor Raghuram Rajan said that the policy stance remains “accommodative”. In other words, more cuts can happen in the year if warranted. In this regard, two key changes over the last policy statement are likely to yield deeper cuts — possibly even more than 25 basis points — for the aam aadmi. One, the cut in the small savings rate in March; and two, the shift to the “Marginal Cost of Funds-based Lending Rate” mechanism for the banks since April 1. The former will incentivise banks to bring down their deposit rates and, as a result, their lending rates. The latter will allow them to charge less on loans since they can base it on the marginal cost of funds instead of the average cost. By staying with fiscal consolidation, the government has avoided a run-in with the RBI. The benefits of this prudence will soon be felt in the form of cheaper loans and EMIs.

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