The monetary policy announced by the RBI on 04th October did oblige the economy and the markets with a 25 basis points rate cut. The monetary policy was unique in a variety of ways. Firstly, it was the first time that the rate setting was driven by the Monetary Policy Committee (MPC) and not by the RBI governor. The RBI governor, who used to have the veto in matters of rate setting, now has only a decisive casting vote in case of a tie. To that extent we have monetary policy that is substantially more institutionalized. Secondly, this was the first policy to be presented by the new governor, Dr. Urjit Patel. While Patel is known to be an inflation hawk, he is also known to be pragmatic and democratic in decision making. The MPC outcome reflected just that. Lastly, the timing of the policy announced was changed from 11 am to 2.30 pm. This gives more time for expectations trades to take shape and forces to trade markets on the next day after a due and deliberate analysis of the nuances of the policy announcement. But, first the highlights of the policy announcement…
Key highlights of the policy announcement…
- The repo rate was cut by 25 basis points from 6.50% to 6.25%. This marks a total of 175 basis points cut in rates since January 2015.
- The cash reserve ratio (CRR) was held at 4% of the net demand and time liabilities (NDTL) of the bank.
- Consequently, the reverse repo rate was correspondingly reduced to 5.75% and the bank rate to 6.75%.
- The RBI has adopted its dual approach to monetary policy by simultaneously focusing on rate signals and liquidity management.
What exactly was the trigger for the rate cut?
The decision to cut rates was broadly driven by 6 factors…
- The sharp fall in overall inflation from 6.07% in July 2016 to 5.05% in August 2016 was primarily responsible for this rate cut decision. This gives the government confidence of moving towards 4% inflation by next year.
- The stickiest component of inflation was food inflation. With food inflation coming down by nearly 300 basis points during August, there was strong evidence that the structural supply issues were being addressed.
- A good monsoon is likely to lead to a record Kharif crop output. With the government now managing its pulses supply more effectively, this is likely to result in better control over food inflation in the current fiscal year.
- The GDP growth is likely to remain under 8% for the next 2 years and lower rates could provide the much needed boost. Additionally, the capital goods sector continues to remain weak and lower rates could give that much needed boost.
- Transmission of rates has been a major worry. According to the RBI estimates, the Indian banks had only passed on 40% of the rate cut to the end customer. Lower cost of funds and better control of NPAs is likely to result in seamless transmission of rates
- Global factors have also aided the rate cut. With the rupee showing strength due to a mix of BOP macros and flows, a rate hike by the Fed in December is unlikely to negatively impact the economics of the INR.
So, what is the outlook for rates from here?
That brings us to the key question, “What does this hold for rates going ahead”? The next policy of the RBI is scheduled on December 07th. While there will be clarity on US elections by then, the Fed will make its stance clear only around the middle of December. Hence, the RBI may not be too keen to cut rates further in December. Also, the month of December tends to be the month when FPIs tend to stay light on Indian markets and hence RBI would prefer to avoid a rate cut at that point of time. But if the Fed continues to maintain a lower trajectory on rates and avoids a hawkish outlook, then the RBI will have room for another rate cut in February this year. That will make it another 25 bps before the end of the fiscal. That will be the good news for the Indian financial markets.