StatsGuru: Will the repo rate cut work?

The Monetary Policy Committee (MPC) surprised many by cutting the policy rates by 25 basis points (bps). That's because many believed that the timing was not right because not enough had changed on the inflation front to justify a rate cut. Chart 1 shows the movement of inflation based on Consumer Price Index (CPI) and Wholesale Price Index (WPI). Barring the sharp decline in retail inflation in August, both CPI and WPI have been higher, on an average, in 2016 than 2015. Moreover, as Chart 2 shows, even the Reserve Bank of India (RBI)'s household survey shows that the three-month and 12-month inflation expectations have been trending north. In fact, RBI's own forecasts for retail inflation ending March 2017 and March 2018, shown in Chart 3, have either moved up or remained "sticky" at a high level. (Click on the image to enlarge)

However, instead of looking backwards at inflation, the MPC seems to have placed its faith on a steady fall in food prices, which essentially led to the fall in August inflation. In sharp contrast to the immediate past, the MPC has tried to target growth. The picture on this count is grim since the global growth engine has been decelerating, as shown in Chart 4, and the domestic economy is increasingly starved of private investment demand, as shown in Chart 5. The hope is that the interest rate cut would further boost aggregate demand, which is already expected to rise with higher rural incomes and the payout of the Seventh Pay Commission awards in the urban areas. A good momentum could help re-energise private investment.

But there is a major hurdle in the form of poor policy transmission. As against a 150-bp cut since January 2015, the State Bank of India lending rate, a proxy for all banks, has come down only by 70 bps. There are possible threats as well in the form of a possible rate hike by the US Federal Reserve and the impact of the goods and services tax (GST). Will GST lead to higher inflation in the coming years? The global evidence, as shown in Chart 6, is mixed.