Why Raghuram Rajan slashed the repo rate to 7.5 per cent

Four days after the Union Budget announcement, the Reserve Bank of India (RBI) Governor Raghuram Rajan has reciprocated by reducing the policy repo rate, the rate at which banks borrows fund from the Central bank, by 25 basis points from 7.75 per cent to 7.5 per cent.

So, why now? The RBI Governor, who was eagerly awaiting the fiscal deficit numbers, seems to be satisfied with the fiscal consolidation programme. "The fiscal consolidation programme, while delayed, may compensate in quality, especially if state governments are cooperative," says the RBI statement. Under the Budget, the fiscal consolidation target of 3 per cent by March 2017 has now been delayed to March 2018.

Rajan, however, has some short-term worries with the deficit. "The postponement of fiscal consolidation by one year will add to aggregate demand," he says. "At a time of accelerating economic recovery, this is, prima facie, a source for concern from the standpoint of aggregate demand management, especially with large borrowings intended for public sector enterprises."

Currently, inflation is already below 6 per cent, and crude prices have softened big time over the past few months. The rupee value against the US dollar (threat of imported inflation through currency) is also stable. Going forward, the RBI will seek to bring the inflation rate to the mid-point of the band of 4 (+/-2) per cent provided for in the monetary policy agreement with the Central government, that is, to 4 per cent by the end of a two-year period starting fiscal year 2016-17.

"Given low capacity utilisation and still-weak indicators of production and credit off-take, it is appropriate for the Reserve Bank to be pre-emptive in its policy action to utilise available space for monetary accommodation," says the RBI statement.

It may be remembered that RBI had cut the repo rate by 25 basis points in mid-January this year, which was the first such instance in the past two years. There is a likelihood of further cuts if inflation remains in the targeted trajectory.

Rajan also has words of caution. "The uncertainties surrounding any inflation projection are, however, not insignificant. Oil prices have firmed up in recent weeks, and significant further strengthening, perhaps as a result of unanticipated geo-political events, will alter the inflation outlook.

"Food prices will be affected by the seasonal upturn that typically occurs ahead of the South-West monsoon and, therefore, steps the government takes on food management will be critical in determining the inflation outlook. Finally, the possible spill-over of volatility from international financial markets through exchange rate and asset prices channels is also still a significant risk."

So why now? The , who was eagerly awaiting the fiscal deficit numbers, seems to be  satisfied with the  fiscal consolidation programme. "The fiscal consolidation programme, while delayed, may compensate in quality, especially if state governments are cooperative," says the RBI statement. Under the Budget, the fiscal consolidation target of 3 per cent by March 2017 has been now delayed to March 2018.

Rajan, however, has some short-term worries with the deficit. "The  postponement of fiscal consolidation by one year will add to aggregate demand. At a time of accelerating economic recovery, this is, prima facie, a source for concern from the standpoint of aggregate demand management, especially with large borrowings intended for public sector enterprises," he says.