Fourth Bi-Monthly Monetary Policy Statement on September 29, 2015 by Governor Rajan: Key takeaways

RBI projects inflation at 5 to 5.5% over the next year

RBI Watch                                                                                    Monetary Policy 2015-16

Governor Rajan announced a 0.5% cut in the repo rate to 6.75%. A cut of 0.25% had been widely expected, so the larger cut was welcomed by borrowers and investors. In my blogs of September 2 and September 18, I had suggested that the RBI should reduce the rate.

Before I go into the key takeaways from the bi-monthly monetary policy statement (MPS), let me recap RBI’s mandate from the government as per the Monetary Policy Framework agreement of February 20, 2015. The RBI’s mandate is to bring CPI inflation down to 6% by January 2016, and then in all subsequent financial years down to 4% with a band of +/- 2%. 

Here are the key takeaways from Rajan’s statement and the media/analyst conference call.

The MPS states RBI’s new interim target in getting to the final target of 4% inflation rate: by end of fiscal 2016-17, the RBI will aim to bring inflation down to 5%. 

  

The RBI has been following a real interest rule of 1.5 to 2%. The question that then arose is which instrument’s interest rate it is looking at to determine whether the rule is being met. For example, is it the 3 month deposit rate or is it the 2 year treasury bond? At the media call, Rajan revealed that the RBI’s bench mark instrument is the rate on the 1 year treasury bill. He indicated that normally this rate is about 0.25% above the repo rate.

Where does RBI see inflation over the next 1 year? RBI’s projected inflation is in the region of 5 to 5.5%. Why? In the MPS, Rajan asserts that after the 0.5% reduction in the repo rate, the 1 year treasury bill rate will be consistent with a real rate of 1.5 to 2%. This means that he expects, all things being equal, for the treasury bill rate to move a little downwards to 7% - 0.25% above the new repo rate of 6.75% - and this would then lead to a real rate of 1.5 to 2%. This leads to a projected inflation rate of 5 to 5.5% over the next one year.

RBI’s one year projected inflation rate also explains why the RBI took the step of cutting the repo rate by 0.5% and not 0.25% as most people had expected. Let’s look at the key factors that support this reduction. Demand conditions in India are weak: capacity utilisation is estimated at 70-72%. The world has suffered a commodity shock, and commodity prices are expected to remain soft. World demand is also very weak.

So if all goes according to plan, I expect no change in the repo rate or at best another 0.5 % cut in the repo rate over the next twelve months. The next cut may well come in the next financial year. 

The RBI will use some of this breathing space to develop better mechanisms to make sure that banks pass on the bulk of the 1.25% cut in the repo rate to its customers. While deposit rates have come down, banks have been reluctant to pass on fully the cut to borrowers –it is estimated that banks till now had passed on only 0.3% of the 0.75% cut in the repo rate before the September 29 MPS. 

One measure that the RBI is considering is forcing banks to price their loans on the basis of marginal cost of funds. I wonder whether this is the right approach. Please see my blog of April 14, 2015 on this subject. Another measure could be to reduce the rates on government’s small savings or rather to get the government to pay interest in line with market rates.

Below are my projections for the repo rate going up to the end of financial year 2017-18. If RBI achieves its target of 4% inflation by March 2018, the repo rate should be in the region of 5.25 to 5.75%.