Ind-Ra: Monetary Policy Framework Agreement Prompts RBI to Cut Rate

In a surprise move the Reserve Bank of India (RBI) cut the repo rate by 25 basis points. As a result the repo rate now stands at 7.5% and the reverse repo and marginal standing facility rates at 6.5% and 8.5% respectively. India Ratings & Research (Ind-Ra) welcomes the move and maintains its view of another 75bp cut in repo rate in FY16.

Ind-Ra believes that rate cut, once again outside the cycle, has been triggered by four factors (i) an agreement between RBI and Government of India (GoI) on the monetary policy framework (ii) expectation of softer inflation in 1HFY16 (iii) RBI's assessment that the central government's fiscal consolidation though delayed may compensate in quality in the medium to long-term and (iv) low demand side pressure as reflected in low capacity utilisation and weak credit off-take.

The last few days have witnessed a number of significant and important announcements from the perspective of the way both fiscal and monetary policy will be conducted in the future in this country. The monetary policy framework agreement between the RBI and the government of India (GoI), released yesterday states that RBI will aim to bring inflation below 6% by January 2016 and the target for FY17 and all subsequent years shall be 4% with a band of +/- 2%.

With this agreement India now joins a select group of countries such as the UK, US, and Brazil that have explicit inflation targets. Ind-Ra welcomes the move and believes that this will bring in more transparency in monetary policy decisions. However, we also feel that as much of the inflation in India arises due to supply side issues relating to food and fuel, this will complicate the matter for the RBI.

Union budget FY16 announced setting up a Public Debt Management Agency (PDMA) this fiscal. The intention of setting of a PDMA was first mooted in the FY08 budget and since then a public debt management office has been functional in the ministry of finance. Once PDMA comes into existence and becomes operational, the RBI will cease to be the manager of GoI's public debt.

Ind-Ra believes while this may put to an end the possible conflict of interest, if any, between RBI's role as a monetary policy making institution and debt manager of GoI, it strongly believes an institutional mechanism will have to be put in place for coordination between PDMA and RBI. This is crucial for developing and strengthening India's sovereign yield curve, because without a low and stable inflation it will be difficult to sell fixed coupon government securities, particularly of longer maturities. In countries where debt management has been separated from the central bank such a mechanism has been put in place. However, in the backdrop of public debt auction failures in the United Kingdom in 2009 and Germany in 2011, questions have been raised about the efficacy of such arrangement as well.

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