RBI Governor’s April 5, 2016 monetary policy statement: RBI should keep rates on hold

From today bank loans based on marginal costs of funds and a lower small savings rates on government schemes come into effect – this by itself may lead to further monetary easing

Monetary Policy                                                                                                     2016-17

In my earlier blogs, October 8, 2015 and December 11, 2015, I had said that I do not expect the RBI to reduce the key policy rate – the repo rate – till the new financial year 2016-17. This time I was right – rates have been on hold since Sept 2015.

I also suggested that the RBI could reduce the policy rate by at best 0.5% in 2016-17.

We are now into the new financial year and Governor Rajan’s monetary policy statement is due in a few days. What should we expect from the RBI?

My view is that the RBI should make no change in the repo rate, currently set at 6.75%.

Over the last twelve months, inflation has followed the path the RBI expected. February’s reading of CPI inflation came in at 5.2%; this suggests that the March number due to be released later this month  will likely indicate inflation below 6% for 2015-16.

RBI expects inflation to move lower to 5% by the end of the current financial year, 2016-17. At 6.75%, the repo rate builds in a real interest rate of 1.5 to 2%. This is RBI’s target. Hence my view that the repo rate should be kept on hold.

The disinflationary bias continues in the world – recent estimates of world growth have seen a downward revision. The world economy is expected to grow about half a percent below its trend rate. Commodity prices are low by historical standards.

India’s budget focuses on rural, social and infrastructure spending; incremental reforms have taken precedence over high visibility structural reforms. There is no relaxation in the central budget deficit target of 3.5 of GDP, although many observers have raised question marks over the maths behind the budget numbers, and the fact that some numbers appear to be off-budget.

In this context, it will be interesting to see the path of inflation that RBI sets out in its monetary policy statement to be released on April 5. My view is as the financial year unfolds if the actual trajectory of inflation turns out to be in line or better (lower) than the RBI’s expected path, then a case can be made to reduce the repo rate. Or there must be strong grounds for the RBI to believe that this will be so.

One key factor to consider is how bountiful this year’s monsoon will be. Rain in January and February has been below normal. Reports suggest water scarcity in some parts of India during the current sowing season. I believe estimates by the IMD on the extent of rainfall during the monsoon season will be first released in April. It would be appropriate for the RBI to take this factor also into account before considering any change in the repo rate. So I believe the RBI should not change the repo rate till its second  bi-monthly monetary policy statement, which should be in June.

RBI has been attempting to improve the pass through of its accommodating monetary policy stance to the end customer - small businesses, corporates and home buyers – without much success. RBI has cut the rate at which it lends to banks, the repo rate, by 1.25% since January last year. Banks in turn reduced deposit rates, but did not reduce their lending rates commensurately.  Governor Rajan has on many occasions exhorted banks to pass on more of the reduction in deposit rates to borrowers, but bankers did not heed his advice.

Finally, the RBI late last year issued a diktat to banks: effective today, banks will have to price new loans based on the marginal cost of funds (MCLR). The RBI needs to watch the MCLR of banks for some time to see whether banks reduce their lending rates in the current financial year.  If banks do respond, further monetary easing will have taken place. This is another reason why RBI should keep the repo rate on hold.

Another attempt to improve the pass through of its accommodating monetary policy stance to the end customer - small businesses, corporates and home buyers – was to get the government to align small savings rates to market rates. Government has acceded to the request of the RBI: two weeks ago the government reduced rates on various small savings schemes by 0.5% to 1%, and announced that in future rates would be reset every quarter. This is a sensible development which comes into effect today.

Here again, the RBI needs to watch how banks respond to the closer integration of the small savings schemes of the government with the larger market for bank deposits, and see whether the expectation that banks will now reduce their deposit and lending rates materialises.