Monetary policy: Here's why RBI may go for rate cut on Thursday

As the Reserve Bank of India’s (RBI’s) Monetary Policy Committee meets on Thursday to take a call on whether to cut or pause rates, Bank of America Merrill Lynch (BofA) has cited several reasons why the central bank might opt for a 25 basis points cut. Interestingly, a Business Standard poll of 10 economists and bond market participants on this question saw mixed results. However, BofA says the RBI will not only cut rates now, but will follow it up with another 75 bps cut in rest of the financial year 2020-21 (FY21).

Here are the reasons for the cut:

6% FY21 GDP contraction

The Covid-19 shock is expected to contract gross domestic product (GDP) by 20% in the June quarter and 6% in FY21 in BoFA’s base case. This assumes that unlock measures will extend to mid-November with the restart taking six weeks to December.

CPI inflation on weak fundamentals

Consumer price index (CPI) inflation should slip to 2.5% in H2FY21 from 6.4% estimated by BofA in July, as supply side disruptions (evident in a growing wedge between CPI and WPI food prices) and methodological issues are ironed out. Apart from favourable base effects ahead, fundamental drivers remain weak: GDP contraction, improved sowing, and low “imported” inflation.

High real lending rates hurt growth

High real lending rates might hurt growth beyond the Covid-19 shock. While nominal MCLR (marginal cost of funds based lending rate) has reduced by 105 basis points (bps) since March 2019, real MCLR is still up by 44 bps

‘Busy’ industrial season begins in October

Time is running out for RBI rate cuts with the “busy” industrial season beginning in October. As loan demand picks up seasonally, transmission of RBI easing would become more difficult

Rising money supply growth

Rising money supply growth, at 12.4% above our 9.1% forecast, constrains the RBI from trying to contain yields through quantitative easing ($105 billion Open Market Operations) as freely as in the past. It is for this reason BoFA expects the RBI to extend HTM (held to maturity) to its estimated additional borrowing of 4% of GDP/5.3% of NDTL (net demand and time liabilities) as well as buy foreign exchange ($17.2 billion) forward.

Adequate forex reserves 

Adequate foreign exchange reserves should provide room for the RBI to cut rates and support recovery. BoFA estimates that the RBI can sell $50 billion to defend the Indian currency in case of a speculative attack.