Does RBI really want rates to fall?

Without simultaneous increase in money supply, transmission of rate cuts is unlikely

Despite its continued hawkish stance, the Reserve Bank of India (RBI) has cut the repo rate by 25 basis points (bps) on Friday. But this is unlikely to result in interest rate cuts because the central bank intends to keep a tight leash on money supply (M3). Over the last couple of years, bankers and RBI have been sparring over M3 and its effect on inflation. Bankers have a more heterodox approach to M3, and believe the distributional structure of the economy affects prices and not M3. However, RBI appears convinced about the causal link between inflation and M3 and, therefore, has kept the latter tight. From the time RBI has declared war on rising prices, growth in M3 has slowed from 20 per cent levels to 13 per cent now. M3 growth decelerated to 11.2 per cent by end-December.

So, RBI's repo rate cut needs to be seen in the light of tight liquidity conditions and lower transmission. Possibly the central bank is sending out a message to banks that it isn't supportive of a lower interest rates regime just yet. Abheek Barua, chief economist at HDFC Bank, says: "A sharp reduction in interest rates does not seem to be RBI's objective. In the absence of any simultaneous announcement on infusion of liquidity, banks will find it difficult to transmit the rate cut. The central bank is not interested in increasing money supply to 17 per cent levels till inflation is under control."

The central bank may have given in to the market's clamour, but it has not cut the cash reserve ratio. RBI cannot be blamed for its rather orthodox approach to inflation as the risks are real and would be fuelled by infusion of more money. In good times, RBI could have printed money against its foreign currency reserves, but given India's depleting reserves and high current account deficit, this is not feasible. RBI can also create fresh supply by modifying reserve requirements, lowering short-term interest rates and purchasing bonds through the open market route. A near total transmission of monetary policy would be possible when inflation slows, deposit accretion picks up and the gap between credit and deposit growth narrows.

Apart from this, there could be another reason why RBI would want to hold on to rates. According to Dinesh Thakker of Angel Broking: "The space for monetary easing appears limited, considering the need to keep the differential with the global interest rates high, so as to continue attracting capital flows to plug the precarious current account deficit."