It almost appears like a fait accompli. The US Fed has maintained status quo on rates in September and hence the door is open for Dr. Rajan to cut rates in his September 29 review of monetary policy. Actually, it may not be as simple as that. A rate cut will not be as simple as it appears to be. From a practical standpoint, the RBI governor will be weighed down by a plethora of variables before he decides on a rate cut on September 29. These variables will impact not only the rate cut decision but also the extent of rate cut that the RBI will undertake in the forthcoming policy meet.
Is inflation actually under control?
Dr. Rajan has reiterated that the inflation figures for the month of August and September can be misleading. This is due to the base effect. Due to a high base figure in the previous year, the inflation for the months of August and September tend to look a little too benign. Typically, October and November inflation will give a clearer picture since the base effect will be removed. Then there is the added uncertainty over food inflation. Monsoons for the year have been about 14% short of mean normal rainfall. If as a result, food inflation tends to shoot up then it could land the government in a piquant situation. That is the first variable that the RBI governor will have to deal with on September 29 when the rate decision is made.
Is the transmission of rates really happening?
That is the million dollar question! Over the last 2 policies, the RBI governor has pointed out that only 40% of the actual rate cut has been transmitted to industry. That largely defeats the purpose of rate cuts. Indian banks have their own set of problems at two levels. Firstly, the high level of NPAs in most PSU banks is an added cost. It makes easy transmission of rate cuts almost next to impossible. Secondly, most banks determine based on their average cost of funds, which is higher than the incremental cost of funds. Hence full transmission can only happen after a lag. The big challenge for Dr. Rajan, therefore, is whether he should risk rate cuts where the transmission benefit will not be visible?
There is a currency angle to the rate story…
The RBI looks at interest rates on one side and the currency value on the other side. A rate cut is actually tantamount to depreciating the INR. This may be at cross purposes with the RBI currency strategy, where we have seen the RBI expending dollars to defend the rupee around the 67/$ mark. The rate decision on September 29 will be a trade off between these two variables. If China tends to devalue the Yuan further, then the RBI may have a big challenge on hand; how to cut rates without weakening the rupee? After all, an import intensive economy like India cannot be too lax about a weak currency.
US rate decision and capital flows…
Remember, the US has put off the rate hike decision, not abandoned it. India relies heavily on capital flows to fund its fiscal and revenue deficit. We are already seeing pressure on flows due to a risk-off trade. This pressure can get sharper once the US hikes rates. India would not want to risk that kind of a scenario where India cuts rates and that leads to sharper outflows from India. That will be a very critical point to bear in mind when the RBI decides on rates.
In conclusion, it will be a difficult task for the RBI to decide on a rate cut. We could see the first sign of a Monetary Policy Committee (MPC) approach to rate setting this time around. That means each member of the committee becomes a critical decision input, although the final veto may still be with the RBI. One can anticipate that the RBI may probably try to soothe frayed nerves by implementing a 25 basis points rate cut. Anything above that could be a very difficult decision for the RBI at this point of time.
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