A calculated gamble

The rate cut is the MPC's way of supporting domestic growth

The six-member Monetary Policy Committee (MPC) surprised many in its first bi-monthly monetary policy review by unanimously opting to cut the repo rate by 25 basis points. The decision, the policy statement said, was in line with the accommodative stance of the Reserve Bank of India (RBI). In fact, the sharp fall in retail inflation in August to 5.05 per cent as well as the MPC's expectation of a rapid decline in the coming months seem to have been the central factors at play. In particular, policymakers expect food prices to decline substantially in the months ahead, given that 85 per cent of the country's geographical area received normal or excess rainfall and, as a result, advance estimates peg the kharif grain production at a record level.

While the MPC has not reduced the headline inflation target for March 2017, it has tweaked its stance by stating that the risks are "tilted to the upside albeit lower than" in the June and August policy statements. To be sure, there were other reasons as well that influenced the MPC to relax the hawkish stance so far on inflation. The government's measures to cool food inflation pressures, especially with regard to pulses, were a part of these. The MPC also felt that the easy liquidity conditions engendered by the RBI should help in the transmission of the policy action. Add to this the fact that the government has cut the small savings rate, which despite being a politically difficult move will further help transmission. Last, but not the least, the MPC has taken a holistic view of the threats and opportunities on the growth front. The threat comes from the sharper than anticipated deceleration in global growth in 2016, with weak investment and trade suppressing aggregate demand. But the domestic economy looks more promising, with agricultural growth boosting rural demand and the Seventh Pay Commission award nudging urban demand. The rate cut is the MPC's way of supporting the domestic growth momentum.

However, there are several imponderables on the horizon, which was the main reason why most observers expected the MPC to wait it out in its first outing. The first and foremost is the uncertainty associated with the actions of the US Federal Reserve. Labour costs and core inflation in the US are close to the Fed's target level and a rate hike is quite possible during its December review. Related to this is the uncertainty of the US presidential election. Domestically, too, there is uncertainty with India's relations being strained with Pakistan. Finally, there are developments that can mar the outlook on inflation, possibly the trigger for the rate cut. One, the ground reality up till now has been that despite adopting the new marginal cost-based lending rate (MCLR), banks have been reluctant to pass on the rate cuts in full measure. Moreover, even the MPC admits that inflation, excluding food and fuel, "has been sticky around five per cent, mainly in respect to education, medical and personal care services". As it is, household surveys consistently suggest heightened inflation expectations. This could get a tad worse with the impact of the pay hikes as well as the bump up due to the implementation of the goods and services tax.