Financial Sectors: Scope for easing monetary policy

Survey says RBI's stance is 'neutral', not 'accommodative', as the central bank claimed

The Economic Survey indicated that the Reserve Bank of India (RBI) could be behind the curve in rate cuts and the policy stance was actually "neutral" rather than "accommodative", as the central bank claimed.

"There is scope for easing monetary policy in two ways, one to inject liquidity to bring it in line with the current policy rate and second is given our inflation projections and assessment going forward, perhaps there is more scope for easing the policy rates as well," he said.

RBI should be able to meet its inflation target of five per cent by March 2017, the Survey said. "Indeed, with the current stance, there is a possibility of undershooting. While the current policy rate seems 'neutral' in that it is only modestly higher than consumer price inflation, liquidity conditions are unusually tight, impeding the pass-through of recent declines in policy rates to the actual bank rates faced by borrowers."

While banks have time and again complained about the tight liquidity situation, RBI had maintained that the central bank was ready to infuse as much liquidity as required to keep the overnight call money rate at around the policy rate.

The central bank infuses liquidity through dated repo windows. Recently, RBI had stepped up its bond purchase from the secondary market to infuse more long-term liquidity. However, bond rates have spiked and was consistently above 100 basis points over the policy repo rate. Banks frequently blame this hardening of yields as a reason for not cutting rates. The Economic Survey seemed to have taken the side of the bankers.

While projecting that the Consumer Price Index (CPI)-based inflation would ease to between 4.5 and 5 per cent in 2016-17, the survey elaborated the effective stance of monetary policy could be relaxed and in two ways. "First, by easing liquidity conditions to make them consistent with the current policy rate ... Second, by further lowering the policy rate consistent with meeting the inflation target while supporting weakening economic activity and corporate balance sheets."

"Robust measured growth of real GDP may not warrant an easing of monetary conditions. But a risk framework combined with a focus on the more reliable nominal aggregates is useful," the Survey said, elaborating that if real growth was weaker than suggested by the headline number, easing would be appropriate. But if real GDP growth was robust, "the implied disinflation is large, mitigating the inflationary risks of easing."

Furthermore, the Survey pointed to incomplete transmission of the monetary policy as one of the factors for sluggish growth of bank credit. This was because banks have not passed on the entire benefit of the repo rate cut (the rate at which banks borrow from RBI) to borrowers.

While policy rates have been reduced substantially - with four rate cuts of 125 basis points in 2015 - bank lending rates have only fallen by around 50 basis points. However bankers have clarified that they were reluctant to cut rates but were only waiting for the cost of funds to come down, which was a lag effect.