By Invitation. Expect at least one more rate cut this fiscal

The third bi-monthly review of monetary policy for 2015-16 was announced against the backdrop of the monsoon doing better than expected.

While the RBI maintaining status quo on policy rates was expected by economists, banks and financial market intermediaries, industry and government were clamouring for a rate cut. Most of the interest rates are linked to base rates of banks, which are, in turn, linked to the repo rate. Any rate cut will provide some comfort to over-leveraged corporate balance sheets and also help banks to reduce some stress.

The borrowing cost of both Central and State Governments is also impacted by movements in policy rates. The yields on 10-year government securities decreased marginally to 7.837 per cent on August 5, from 7.881 per cent on January 1. Earlier, on June 1, the 10-year G-Sec had declined to 7.64 per cent, from 7.737 per cent on March 31, in expectation of a significant monetary easing.

Although some would argue, the Governor should have taken a risk and cut policy rates further, it was only after the June monetary policy made it clear that there was a low probability of further monetary easing that rates hardened in June and July.

Maintaining status quo was a prudent decision. While food inflation has withstood two adverse weather shocks — sub-par monsoon in 2014 and unseasonal rains in early 2015 — the prices of vegetables have shown an upward trend in July and August (the lagged effect of unseasonal rains on crops such as onions).

In addition, the favourable base effect would start waning from September 2015. The impact of the monetary policy is felt with a lag. The CPI inflation target is 4 per cent and the policy has to be framed accordingly.

Inflation expectations of households, which had declined to single digits in December 2014 (8.9 per cent) and March 2015 (9.1 per cent), returned to double digits (10.3 per cent) in June. Monsoon still holds the key. After excessive rains in June (13 per cent above normal), cumulative rainfall till July 29, was 3 per cent below normal.

While the India Meteorological Department has retained its monsoon season (June-September) forecast of 12 per cent below normal rainfall, private weather forecaster Skymet has forecast it at 98 per cent of normal rainfall, slightly below its earlier forecast of 102 per cent. Kharif sowing (till July 31) was 8.65 per cent more than last year. However, it is still 2.22 per cent lower than normal sowing. This means the risk to kharif crops and consequently the risk of higher food inflation remains. Also, unseasonal rain has a lagged impact on the prices of vegetables and is most pronounced in case of onion. If rains are deficient, kharif crops may have a cushion from higher reservoir levels.

Quite often the reason given for cutting the policy rate is that it will spur investment demand. It is expected that the real interest rate for 2015-16 will be towards the lower limit of 1.5-2 per cent range (average repo rate for the year, net of average CPI inflation). Interest rate is a necessary but not a sufficient condition for investment and demand conditions are a major driver. Although capacity utilisation increased to 75.2 per cent in Q4 2014-15 from 70.2 per cent in Q1 2014-15, it is still lower than the 76.2 per cent attained in Q4 2013-14. Comparing Q4 utilisations, 2014-15 numbers are the lowest of the last six fiscals. With such excess capacity domestically and globally (mainly China), it is unlikely that a repo rate cut would have revived investments.

Decline in inflation, monetary easing done by RBI so far and median 30-bp cut in base rate by banks will help revive consumption demand. RBI’s survey of professional forecasters’ results suggest private final consumption expenditure at current prices to grow 12 per cent 2015-16 (70 bps lower than the previous survey). Factoring in the decline in inflation, real consumption growth in 2015-16 is likely to be better than in 2014-15. This will increase capacity utilisation.

The government is front loading plan expenditure in the hope that the private/corporate sector will follow the government’s efforts to revive the investment cycle. Continuity in the reform process and removing structural bottlenecks are key to sustaining a growth revival.

At least one more rate cut of 25 bps is likely in this fiscal year. However, this will depend on market behaviour after US monetary tightening.

The improved current account situation, increased forex reserves and continuity of capital flows this fiscal, have improved the resilience of the Indian economy to withstand this change.