The Reserve Bank of India (RBI) has done what it could. The surprise 50 basis points (bps) rate cut on September 29 took the cumulative reduction in policy rate to 125 bps in the first nine months of 2015. The RBI has also lowered its GDP growth forecast by 20 bps to 7.4 per cent (Crisil’s GDP growth forecast, too, is 7.4 per cent) and its January 2016 inflation forecast to 5.8 per cent from 6 per cent estimated last month.
The slack in the economy, downside pressure from global crude and commodity prices, and the government’s proactive food management policies had made it near certain that the RBI’s inflation target of 6 per cent by January 2016 will be undershot. The postponement of a rate hike by the US Federal Reserve towards the end of 2015 has also helped. These developments afforded Governor Raghuram Rajan the elbowroom to cut rates to the extent he could. And so he did. We do not expect him to wield the knife anymore this year.
The onus is now on the government to remove impediments to transmission, even as it follows a prudent fiscal path and cuts the small savings rate. And banks have to pass on the benefit. The RBI’s policy is likely to remain accommodative, but it will keep a hawk’s eye on demand-side pressure on inflation that could arise from the Seventh Pay Commission payout expected in the next two fiscals.
To reap the benefit of the latest rate cut, its transmission to lending rates should accelerate. Several public sector banks have responded by reducing their base rate. I believe others will follow suit. As a result, automobile and housing loans could become a little bit cheaper. Whether consumers respond to this remains to be seen.
In any case, much more needs to be done to reduce the delay and dilution in interest rate transmission. First, the government has to lower the small savings rate that has been a barrier to banks inclined to snip. To be sure, the government has confirmed its resolve to review the rate but that’s easier said than done. Second, banks need to fix their lending rate based on marginal cost of funds. This will happen soon, as the RBI guidelines to this effect will be released in November.
Crisil’s estimates show that the change in methodology can lower banking system base rates by approximately 50 bps from current levels. In the process, banks will also cop a one-time hit of Rs 20,000 crore in profit. The RBI also wants banks to offer floating rates of interest for term deposits. This change should, over time, improve the transmission of the RBI’s policy rate cuts to bank lending rates.
As for inflation, despite the recent climbdown, caution is warranted, given the legacy in India. Consumer price inflation declined sharply to 6 per cent in fiscal 2015 from 9 per cent in 2014, after running in double digits in the preceding five years. It fell to 3.7 per cent this August and seems on course to beating the RBI’s target of 5.8 per cent in January 2016. The central bank’s recent move reflects its flexibility in adjusting policies to evolving growth-inflation dynamics.
Even with inflation currently at levels lower than expected, there can be no complacency. India is lucky to be supported by the disinflationary trend in global commodities, but keeping a lid on domestic food inflation this year will require continuous monitoring and proactive steps from government, such as adroitly managing imports and checking hoarding. But the larger issue related to food inflation is low farm productivity, wastage, and high vulnerability of agriculture. It’s necessary to address these for a durable fix on food inflation and to ensure a smooth transition to the 5 per cent CPI inflation target for fiscal 2017 and eventually to 4 per cent.
The writer is chief economist, Crisil.
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