The future path of RBI’s policy rate: What does it mean for borrowers, depositors and investors?

Scenario Analysis if RBI achieves its mandated central target

RBI Watch                                                                                    Monetary Policy 2014-15

The Monetary Policy Framework of February 20 this year between the government and RBI lays out in explicit terms RBI’s mandate: CPI by January 2016 should be 6%, and from then on in subsequent financial years 4% plus or minus 2%.

Last week, in an inter-meeting move, the RBI reduced the repo rate by 25 basis points to 7.5%. Given RBI’s determination to keep the real rate 1.5 to 2% above the policy rate and assuming inflation does reach close to 6%, the repo rate should be still at 7.5% in March 2016.

Today inflation is about 5%. In fact, inflation has fallen at a much faster pace than projected by the RBI. So, should this not push the RBI to lower the repo rate to about 6.5%? If inflation is sustained at this level or falls further, then RBI will be under pressure to lower the repo rate. But it would not want to be caught in a situation where it lowers the rate, but is then forced to raise it again if inflation rises as the January 2016 target date is reached. Hence, my sense is that RBI as far of possible will keep the repo rate at the current level of 7.5%.

Note also the US Fed is expected to raise the federal funds rate later this year, as early as June. RBI would like to manage successfully possible capital outflows and rupee volatility around this event. Hence it makes sense to make no further reductions in the repo rate for now.

Moving to the next target, if inflation trends lower to the central target of 4% by March 2017, the repo rate should be about 5.5%. So, we are talking about a 2% fall in the repo rate by March 2017.

What does this mean for borrowers? Today, the base rate – the minimum lending rate, ostensibly for the best customers - charged by banks is in the region of 10%: SBI, the largest bank has it at 9.8%, and ICICI bank, the largest private sector bank, has set it at 10%. This means that bank base rates could come down to about 8% by March 2017. Deposit rates will also fall – one year deposit rate could fall from the current 8.75% or so to 6.75%.

Surely, this will be huge positive for India’s bond and equity markets. Prices of bonds vary inversely with interest rates, and lower borrowing rates should increase corporate profits. A thirty percent increase in the SENSEX is a distinct possibility.

Will this scenario pan out?

Inflation has fallen steeply and far beyond the RBI’s expectations because demand has been very weak in India, and the global environment has been exceptional – the developed world is beset by the spectre of deflation. Tight monetary policy by the RBI till recently has played some part.

India wants more growth not less. There are signs that the economy is picking up again, and growth is expected to be about 8% in 2015-16. In the longer run, the government wants a growth rate in the region of 10%.

So, how does the economy grow significantly faster, and yet have significantly less inflation. One step is government putting its finances in order - fiscal consolidation. This means more investment spending as compared to consumption expenditure, and much less leakages in consumption spending. This budget proposes to address both these issues. But we need much more: better governance and more efficiency in government. And we need more reforms in the economy – on this front the government is moving ahead at a steady pace.

On the private sector front, we need more investment. But in many sectors, the private sector is sitting on excess capacity and is overburdened by debt. So it does seem unlikely that there will be a major expansion in private sector investments.

The scale of the change required in two years - by financial year 2016-17 - to increase the productive capacity of the economy appears formidable.

To my mind, a key factor in RBI attaining its target of 4% inflation by March 2017 will be the continuation of the truly exceptional global disflation/deflationary environment we are in today.  Please see my earlier bogs on this subject.

Note: if inflation rises from the current level to 6% by March 2017, RBI would have achieved its target:  4% with a band of +2%.  It will be interesting to see the evolution of monetary policy over the next two years under the Monetary Policy Framework.  What will be RBI’s tolerance for inflation above the central target but within the 2% excess band? Let’s wait and watch.