RBI's challenges

High core inflation and weak transmission key hurdles

The main takeaway from the last monetary policy review of the Reserve Bank of India in February was a growing realignment between the financial stability concerns of the central bank and the economic growth concerns of the Central government. In that sense, the first policy review under RBI Governor Shaktikanta Das was a significant milestone after several months of rather acrimonious interaction between the two sides. The Monetary Policy Committee’s (MPC’s) decision in February had two key elements: The repo rate was cut by 25 basis points; and the MPC altered the RBI’s policy stance from “calibrated tightening” to “neutral” — a move that led many market participants to start expecting another rate cut in the April policy review, due to be announced on Thursday. 

To a great extent, a rate cut, especially of another 25 basis points, is likely. That’s because the headline retail inflation rate has remained well within the RBI’s target of 4 per cent, even though it has moved up a tad. It is quite possible that the sharp downward revision of the retail inflation rate and inflation expectation that marked the February policy may continue to hold steady. Beyond inflation worries, a rate cut is also likely for reasons for poor growth. Fitch Ratings has recently cut India’s growth forecast for 2020 to 6.8 per cent from 7 per cent; and Japanese brokerage Nomura says the likelihood of the Indian economy’s growth dropping below 7 per cent in 2020 is very high. The key indicators paint a worrying picture. For instance, the index of industrial production (IIP) fell by 1.7 per cent in January, as against a 2.6 per cent rise in December. Especially disappointing is the weak performance of the manufacturing and electricity sectors. Similarly, consumer demand across urban and rural areas is weakening. Brokerage houses suggest that consumption across sectors — from cement to steel and from power to automobile — has been faltering. Given the dovish policy stance of the US Federal Reserve and the overall softening of global growth momentum, the MPC is widely expected to push for another cut this time.

However, there are a couple of worrying details that spoil this clear policy prescription. One, while headline inflation remains under control, there has been a growing divergence between the headline numbers, which are lower thanks to extremely low food inflation, and core inflation (that is, headline minus food and fuel), which has stayed persistently high. In fact, according to the latest reading, there is a whopping 6 percentage point gap between the food inflation rate and the core inflation rate. Efficacy of any decision on the repo rate would depend essentially on whether core inflation is expected to lower to the headline inflation level or the other way round. Clearly, there are no easy answers in this regard. The other key concern is the weak monetary transmission in the banking system as is evident from the fact that the last rate cut in February is yet to reflect in loan and bond rates. Banks say monetary transmission will remain partial and delayed due to a wide gap between credit and deposit growth. The MPC needs to take a stand on these two issues when it announces its decision later this week.