What can drive the RBI to cut rates further from here?

When the RBI announced its credit policy on February 02nd, it chose to hold status quo on rates. It also did not move the CRR. There have been diverse expectations in the market about the likelihood of the RBI cutting rates during this calendar year. Estimates range of zero rate cuts during 2016 to 75 basis points cut in rates. The truth obviously lies somewhere in between. Remember, the RBI has cut rates by 125 basis points in 2015 and such aggression may be difficult to see in the current year. However, it will be useful to understand what could trigger the RBI to further cut rates from here on.

Inflation needs to come under control…

Probably, the most important consideration is that inflation should come down. With inflation at 5.6%, the leeway with the RBI to cut rates is too limited. The RBI needs to worry about real rates of interest in India. If rates are cut and inflation goes up then it becomes a double whammy for real rates. That is a situation the RBI would want to avoid.

Inflation has its key components and the most important component currently is food inflation. With an erratic monsoon and poor acreage in the Kharif and Rabi season, food inflation is prone to sharp spikes. We saw that in case of pulses, tomatoes and onions. Food inflation, by definition tends to be sticky and hence difficult to manage. With sharp supply inefficiencies existing in India and many government initiatives not working properly, this will continue to be the thorn in the RBI’s flesh. If inflation is reined below 5%, the RBI may have a strong reason to cut rates in subsequent policies.

RBI will also be keen on transmission…

The RBI learnt in the last one year that cutting rates is one thing and the actual transmission is another matter altogether. This is not something the RBI had bargained for. According to the RBI’s own assessment, out of the 125 basis points rate cut, hardly 60 basis points were actually passed on to the final borrowers. This meant that rate cuts did not actually result in any serious reduction in cost of funds for borrowers, defeating the entire purpose. Unless this transmission becomes smooth and seamless, the RBI may go slow on rate cuts.

The new formula proposed by the RBI to calculate lending rates based on marginal cost of funds is a step in the right direction. However, this seems to have a lot of practical problems in implementation. Senior banks including the chairperson of SBI have raised objections to this model. It remains to be seen how the RBI and banks ensure seamless transmission in practice.

Keep an eye on capital flows, currency and its drivers…

The RBI learnt a hard lesson during the currency crisis of 2013 that FII debt inflows can be extremely fickle if the rate differential is not maintained. In 2013, a combination of low rate differential and a weak rupee combined to result in a $13 billion outflow from FII debt holdings. The RBI would surely want to avoid that kind of a situation. That is why the RBI is keeping an eye on the currency rates and the interest rate differentials. Currently, the spread between Indian 10-year G-Sec and the US 10-year G-Sec is well above the average spread. This has kept the inflows into debt markets buoyant. But if the US were to hike rates and the RBI were to cut rates, then this spread advantage could vanish quite fast. Once the INR comes under attack, then a repeat of 2013 is likely. This is a situation that the RBI would want to avoid.

If the Fed puts off rate hikes, that will help…

The month of March will be critical for the RBI. When the FOMC meets in March, it will be interesting to observe if the Fed chooses to hike rates by 25 basis points or maintain status quo. The street consensus is that they may choose to put off rate hikes to the second half of 2016. That will be good news for the RBI and then they may choose to take a call on rate cuts. That will probably be the most critical trigger for the RBI to decide on rates.

Apart from the above there are some allied considerations for the RBI. The forthcoming Union Budget will be watched to see how the government guides on fiscal deficit. If fiscal prudence goes for a toss, the RBI will be cautious because that is negative for India’s ratings and also for inflation. There is the additional burden of OROP and the Seventh CPC payouts. They are likely to add 0.5% to the fiscal deficit and likely to put pressure on inflation. The RBI may have a tough call on rate cuts in the current year.

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