Why the Street bets on August rate cut

Good monsoon, efficient food management could address risks from inflationary pressures

The Reserve Bank of India (RBI)’s second bi-monthly monetary policy review was largely on expected lines, with no change in policy, rates as well as inflation and growth targets. Uncertainty surrounding Britain's exit from the European Union, India Inc’s upcoming Foreign Currency Non Resident (Bank) account redemptions, and the US Fed rate hike explain RBI’s wait-and-watch. However, upside risks to its inflation target of five per cent, citing rising global commodity prices and higher food prices, among others, mean limited space for further rate cuts in the near term.

The Street, however, was not perturbed by this. Not only was the BSE Sensex up 232 points on Tuesday, the yield on 10-year government securities, too, moved only one basis point on the upside and, the rupee closed 20 paise higher against the dollar. Most economists expect a 25 bps rate cut in the next policy on August 9. Expectation of a good monsoon, which seems to have prevented RBI from raising its inflation target, can keep food prices in check.

“The point is that food is about 45 per cent of the CPI (consumer price index) basket, whereas fuel is only 15 per cent. So, positives in food inflation can more than offset weakness in fuel,” says Pranjul Bhandari, Chief India Economist, HSBC. She believes easing food prices will give RBI scope to cut rates.

Indranil Sen Gupta, co-head and economist, India Research, Bank of America Merrill Lynch, echoes this view. He believes 4.9 per cent GDP growth (on old method basis) in FY16 is well below India’s potential of 7-7.5 per cent and inflation is benign at five-six per cent levels.

Importantly, RBI’s move to review implementation of the marginal cost lending rate framework could prove equally beneficial for India Inc and the economy, if not more, as it will help address the issue of slower rate transmission by banks. While RBI has cut rates by 150 bps from January last year till date, banks have passed about half of these to the borrowers. One of the steps towards better transmission is its plan to ease systemic liquidity (money supply).

Gupta explains, “A rate cut signal will transmit faster into lending rate cuts if the regulator pushes money markets into seasonal surplus by June.”

By August, there will also be a clear idea on the quality of monsoon. A good season along with the government’s reforms on food production and its supply management will help contain food inflation. By August, there will be clarity on the key global events, too. These are among the key reasons why a rate cut is expected in the next policy meet.

However, with the expected recovery in economic growth thereafter, experts believe the August rate cut will be followed by a pause.