25 basis points cut to improve transmission

Economic conditions have converged in favour of another rate cut by the MPC in the April review.  Indeed, domestic interest rate markets are pricing in 100% probability of a 25 bps rate cut and are pricing more than 50 bps cuts cumulatively over next six months.
 
The key change from February is that inflation outcomes have been better than expected and growth outcomes weaker.  Q4FY19 inflation may undershoot the February estimate.  Cons­ensus expectation for FY20 average inflation is now below 4%.  The question for MPC is whether inflation would further undershoot its own FY20 expectations.  There are reasons to be cautious and not stretch the low inflation story.  For one, food inflation may have bottomed out led by price increases in cereals and pulses.  Second, core inflation continues to be well above headline and may remain north of 5% over the next two quarters.  Lastly oil prices are 8% higher than February and only part offset by rupee strength in that period. 

 
On the other hand, both GDP data and high frequency indicators have provided conclusive evidence of slowdown that started in Q2FY19 and has intensified since then. Even as investment demand seems to be picking up, global outlook has turned weak. Consumption demand may recover but mainly due to boost from fiscal policy via cash transfers.  Thus the MPC’s expectation of 7.4% growth in FY20 may be optimistic and require revision.  This should also provide comfort to the MPC that pressures on underlying inflation will weaken.
 

Improvement in external accounts should also provide comfort to MPC.  Although MPC professes to stick to a strict inflation target regime, RBI members of the committee cannot ignore financial stability concerns.  With current account balance improving and capital flows having turned a corner, the currency channel is unlikely to add to inflation pressures.  More important, with global monetary cycle taking a sharp dovish turn, the MPC should not have concerns about being out of sync with rest of the world.  The FOMC has already eased policy by removing expectations of a rate hike and now there is a good probability that it may affect a rate cut this year to take out insurance against a sharper downturn.

 
Overall the case for a deeper easing in India cannot be completely dismissed.  However from the point of view of improving transmission it may be better for the MPC to cut by 25 bps now and push banks to do the needful while keeping something in reserve.  Moreover with a regular Budget in July likely to see increased spending, spacing out rate cuts may be more optimal.  What about a change in policy stance? Given the rapid shifts in global outlook and commodity prices, policy choices keep changing every six months.  To navigate such a climate, neutral stance is the most apposite.  Lastly, RBI should direct questions about high real rates to the government which has perpetuated high rates by fixing interest rates on small savings and EPF well above market clearing levels.

 

(The author is Head-Fixed Income Research ICICI Securities PD )