Dovish tone

RBI eases liquidity, but watches inflation momentum

The Reserve Bank of India (RBI), in its first bi-monthly monetary policy statement for 2016-17, has cut the benchmark interest rate by the expected 25 basis points, to 6.5 per cent - the lowest level since 2011. Importantly, the RBI has signalled that its monetary policy stance remains accommodative; most observers interpret this as meaning that one more cut by a similar margin may be possible later in the year. However, given that inflation as measured by the consumer price index is now at 5.2 per cent, and wholesale prices are still seeing deflation, the real rates faced by borrowers are still significantly positive - despite the current demand and investment crunch. The last three imprints for the monthly index of industrial production have seen a year-on-year decline. Given that, many have wondered if a more significant easing of rates should not have been carried out. Industry, clearly, will remain a little dissatisfied with the monetary policy regime.

A reading of the RBI's statement suggests that Governor Raghuram Rajan, who is determined to establish the central bank's credibility as an inflation-fighter, is not completely satisfied that global uncertainties have died down, and would therefore like to keep his powder a little dry. In addition, the future path of domestic inflation continues to be contingent on the impact of the forthcoming monsoon - as well as of the central pay commission award, the one-rank, one-pension agreement for the armed services, and increases in the service tax rate. Aspects of consumer inflation have edged up in the closing months of the last calendar year, the RBI points out, and it continues to be watchful about the "stubborn underlying inflation momentum". Given this caution, hopes for a deeper cut in interest rates that would bring down the real cost of capital to something manageable for industry have not been realised. Importantly, the RBI continues to express concern about the transmission of current and future rate cuts to actual lending rates, in spite of positive recent developments on this front including the reduction in small savings rates announced last month.

While the policy rate itself has not seen a deep cut, Dr Rajan has stressed the need for using other methods of monetary management. In particular, he has laid out a set of changes to ease the liquidity situation. These include a commitment to lower the average ex ante liquidity deficit from one per cent of net demand and time liabilities (NDTL) to "a position closer to neutrality"; a narrowing of the policy rate corridor by 50 basis points; and a reduction of the daily maintenance requirement of the cash reserve ratio by five percentage points. This is a response to tighter liquidity that the RBI has attributed to "the larger-than-usual accumulation of cash balances by the government, unusually heightened and persistent demand for currency, a pick-up in bank credit, and flatter deposit mobilisation". The RBI clearly hopes that this easing of liquidity conditions, together with a dovish tone to the commentary, makes up partly for cutting rates only by 25 basis points. The real effect of this strategy remains to be seen. Many investors will continue to wait and watch for future action.