Four reasons why Reserve Bank of India may cut interest rates by 25bps
The biggest case for a rate cut, economists say, is in the consistently low inflation that has remained well within the central bank’s targetsbusiness Updated: Aug 02, 2017 09:48 IST
Economists are expecting the Reserve Bank of India’s monetary policy committee (MPC) to announce on Wednesday a 0.25 percentage point cut in the policy rate, which could bring it down to a six-and-a-half-year low.
Lower interest rates will bring down the EMI burden for households, leaving them more room to spend, and help companies increase their borrowings.
Economists, surveyed by Mint, believe the following economic indicators make a case for the central bank to cut the repo rate — the rate at which it lends to banks.
RECORD LOW INFLATION
Inflation has consistently fallen, registering a more than five-year low in June. With the latest reading at 1.54%, the retail inflation is below the MPC’s target range of 2-6% and the RBI’s forecast. The fall could give RBI governor Urjit Patel the “greater clarity” he called for in the last monetary policy review, when he made a case against lowering interest rates to avoid “premature policy action”.
NEED FOR GROWTH
Indian economy has been struggling. India’s GDP growth rate slowed to 6.1% in the March quarter — the slowest in two years — because of demonetisation, and credit growth to companies slowed to a trickle as banks are weighed down by a pile of bad loans. The June quarter earnings data now also points to a slowdown in some sectors ahead of the introduction of the goods and services tax (GST) on July 1.
DIFFERENCE WITH REAL RATES
Banks have largely been reluctant to pass on the rate cut announced by the RBI in October 2016. India’s real rates — the interest rates that banks actually hand out loans at —have remained above RBI’s own assessment range of 1.25-1.75% since the last time the central bank lowered the interest rate. This shows that RBI has room to cut rates without hurting savers, who benefit from the interest on deposits.
THE TAYLOR RULE
Most economists surveyed are right in betting on a rate cut if the so-called Taylor Rule, a yardstick to gauge the appropriate interest rate in the economy, is to be believed. The gap between RBI’s policy rate and the rate path prescribed by the Taylor rule is the widest since March 2015, when the central bank formally adopted inflation targeting. The rule, developed by Stanford University monetary economist John B Taylor, estimates the desired level of interest rates based on the output and the inflation gap. It is a widely used benchmark; Indian policymakers, including RBI officials, have often referred to it in the past.
There a few reasons why RBI could still choose not to cut the policy rate, although this is a remote possibility as things stand.
Firstly, there are several risks to inflation. The RBI believes consumer prices in October-March will rise 3.5-4.5% from a year earlier due to the reversal of the base effect, a seasonal uptick in vegetable prices and the higher HRA payout for government staff. Even then, however, inflation would remain within target.
Secondly, there is scope for banks to fully transmit the past rate cuts. But will the central bank consider this factor not to cut rates, given that banks– reeling under bad loans – stand to benefit from a wider gap in real and policy rates?
Thirdly, by RBI’s own admission, it is comfortable with a higher real interest rate. However, that factor may not be stronger than the increasing pressure from the government to take a decision to spur growth.