There was actually little surprise in the markets when the Monetary Policy Committee (MPC) finally announced a 25 basis points cut in the monetary policy announcement on 2nd August. The debate among traders and economists was more around whether the actual rate cut would be 25 basis points or 50 basis points. In fact, the equity and bond markets would have been pleasantly surprised by a 50 bps cut in the repo rates as the 25 bps cut was already factored into estimates.
However, one thing is extremely significant before we get into the nitty-gritty of the monetary policy. It may be recollected that the MPC had shifted the stance of the monetary policy back in February 2017 from an “Accommodative Stance” to a “Neutral Stance”. It was expected that the MPC would also announce a reversal of stance back to Accommodative. However, the RBI has refrained from shifting the stance for now. In fact, the RBI has reiterated that the 25 bps cut is only in consonance with the Neutral Stance of the MPC. That mean, the RBI still keeps its options open about changing the direction of rates at a future date. But first, a look at the key highlights of the monetary policy announcement!
Key highlights of the RBI Monetary Policy Announcement…
A few key points are to be noted here. The spread of the repo rate over the reverse repo rate and the bank rate has been gradually brought down from 100 bps to just 25 bps. This is, therefore, a rate cut in addition to what the RBI has implemented till date through its policies. Despite the bank rate being languid over the past few months, the surge in deposits post demonetization had led to banks cutting their MCLR (Marginal Cost Based Lending Rate) by 90 bps post demonetization. Hence in the last 1 year, the transmission has been more than 100%. The SLR is going through gradual reduction and has been currently brought down to 20%. However, with most banks holding on to excess SLR to the tune of 700 bps, this may not be too effective as a monetary measure.
Why did the RBI cut the rates despite holding a neutral stance?
As the RBI has explained in its outlook for the economy, the decision was a combination of a sharp fall in inflation and tepid industrial growth. Let us look at the statistics. CPI inflation has fallen to 1.54% in June and food inflation has slipped to (-2.12%). This has been largely led by pulses and vegetables that have remained in negative inflation zone for over 9 months. With the second consecutive above-normal monsoon in 2017 (over 84% of India has received normal rainfall); we can expect further pressure on the prices of pulses. There is already a glut of pulses in the Indian market and that is likely to keep food inflation in check.
But the bigger worry for the MPC was, perhaps, growth. Look at some of the numbers. The IIP and the first quarter GDP have continued to remain tepid. The core sector growth for June came in at just 0.4% compared to 7% in the corresponding month last year. But the bigger worry was the PMI-Manufacturing falling sharply from 50.9 to 47.9 in the month of July 2017. It only means that the manufacturing sector is still tentative about big commitments into its business. A PMI figure of below 50 indicates contraction and that is clearly visible along with loss of momentum on a MOM basis. More than the inflation, the MPC saw this as an opportunity to give a boost to growth via the rate cut mechanism.
Then, why did the MPC cut the repo rates by 25 bps?
As per the MPC statement, there are 2 things that are worrying the RBI right now. Firstly, the food inflation is highly sensitive to base effect and the impact of weak food prices may wane once the true effect of the higher MSP sets in. Also, inflation excluding fuel is already facing above 4% inflation. That means any reversal in oil prices will lead to a sharp surge in inflation. The RBI is also worried that inflation may start going up when the effect of HRA payouts to government employees and the farmer loan waivers take full effect. Under these circumstances, the RBI did not see much of a point in getting aggressive on rate cuts.
Secondly, the RBI is also veering towards the opinion that bank lending is becoming less of a factor in industrial growth compared to insufficiency of demand. The demonetization forced banks to cut their MCLR by up to 90 bps but there are no signs of a recovery in credit off-take. This is in tune with the RBI view that the causality between bank credit and economic growth is gradually weakening. Cutting repo rates by 50 basis points would have tied down the RBI to an accommodative stance, which the RBI wanted to avoid considering the uncertain global cues. The fact that the RBI has cut rates but maintained its neutral stance means that the regulator is keeping its options open.
There really was dissent and debate…
By maintaining the stance of monetary policy at Neutral, the RBI has kept its options open for the future. But the good news is that there were a range of opinions in the MPC. While Dr. Dholakia voted for an aggressive 50 bps cut, Dr. Patra voted for status quo on rates. The other four members, of course, were in tune with the 25 bps cut. The details of the policy discussions will only be known when the minutes are published after 15 days. For now, the rates have been cut but the stance stays neutral. The action now shifts to the next monetary policy to be announced on October 03rd 2017!