RBI's repo rate cut after three years is just a token

The 50 basis point cut in the repo rate - the rate at which the Reserve Bank of India, or RBI, lends to commercial banks - is the central bank's first cut to key lending rates in three years .

Against the backdrop of moderating GDP growth, RBI's policy action on Tuesday could have three possible targets: stabilising growth around its current post-crisis trend, containing risks of inflation and a resurgence in inflation expectations; and enhancing the liquidity cushion available to the system.

After raising the policy rate by 375 basis points during March 2010 - October 2011 to contain inflation and anchor inflation expectations, RBI had paused in its mid-quarter review of December 2011.

So what propelled RBI to bring about such a bold 50 basis point reduction in the repo rate, at a time when market was at best hoping for a 25 basis point cut?

First, growth decelerated significantly, to 6.1 per cent in the quarter ended December 2011, though RBI expects moderate recovery in the growth rate in the quarter ended March 2012. "Based on the current assessment, the economy is clearly operating below its post-crisis trend," RBI said.



Second, headline WPI inflation as well as non-food manufactured products inflation moderated significantly by March 2012.  During December-January, inflation softened on account of a decline in food prices, however, in the following two months, inflation softening was driven largely by moderation in core components reflecting a slowdown in demand, RBI highlighted.

Does this movement signal the beginning of a rate-cutting cycle?  Unlikely, for several reasons.

RBI emphasised that the deviation of growth from its trend is modest. And at the same time, upside risks to inflation persist. "The reduction in the repo rate is based on an assessment of growth having slowed below its post-crisis trend rate which, in turn, is contributing to a moderation in core inflation," RBI said in its annual monetary policy statement. "These considerations inherently limit the space for further reduction in policy rates," RBI added.

Persistent demand pressures emerging from inadequate steps to contain subsidies as indicated in the recent Union Budget will further reduce whatever space there is. In this context, it must be pointed out that while revisions in administered prices may adversely impact headline inflation, the appropriate monetary policy response to this should be based on whether the higher prices translate into generalised inflationary pressures.

Also, despite projecting GDP growth of 7.1 per cent in 2012/13, RBI also highlighted five key risk factors that could negatively impact that projected growth rate. Crude oil prices were on the top of the list. "The outlook for global commodity prices, especially of crude oil, is uncertain," RBI said.

The second risk arises from the central government's fiscal deficit.  The deficit has remained elevated since 2008-09. "The fiscal slippage in 2011/12 was also significantly high," RBI pointed out. "Even though the Union Budget envisages a reduction in the fiscal deficit in 2012/13, several upside risks to the budgeted fiscal deficit remain," RBI added.

Further, the large fiscal deficit has led to large borrowing requirements by the Government, which is the third risk factor. The budgeted net market borrowings through dated securities for 2012/13 at Rs 4,80,000 crore were even higher than the expanded borrowings of Rs 4,40,000 crore last year. "Such large borrowings have the potential to crowd out credit to the private sector," said RBI. "Crowding out of the more productive private credit demand will become more critical if there is fiscal slippage."

The fourth risk factor is the current account deficit, which for the quarter ended December 2011 stood at a high 4.3 per cent of GDP. "This level is unsustainable and needs to be contained," RBI said. "With global capital flows to emerging markets projected at lower levels in 2012, financing of the CAD will continue to pose a major challenge."

And finally, inflation in protein-based items continues to be in double digits with little sign of trend reversal. "This is mainly because of structural imbalances in such commodities," RBI pointed out. The Government has announced some supply-side measures to address protein inflation in the medium to long term. "In the near future, however, the pressure on prices of protein-rich items will continue to be a risk factor for food inflation," RBI added.

Given the tight-rope walk that RBI must perform going forward, there is hardly any reason to believe that interest rates are about to freefall.