RBI Keeps Repo Rate Unchanged: Implications and Takeaways

Repo rate unchanged…

The Reserve Bank of India (RBI) today kept the benchmark repo rate unchanged at 7.25% and the cash reserve ratio (CRR) at 4%. However, Governor Rajan kept the hopes of further rate cuts alive later in the year by reintroducing the phrase ‘accommodative stance of monetary policy’ after having dropped it in the June review. The Governor’s indication of lower interest rates comes despite the fact that the central bank’s inflation projection for January 2016 remains unchanged at 6%, though it is lower by 0.2% for the period January to March 2016 due to soft crude oil prices. 

RBI to wait for significant uncertainties to resolve in the coming months….

The central bank was largely expected to maintain a pause in policy move as the retail inflation had crept to a nine-month high of 5.4% in June. Moreover, it is likely to wait for significant uncertainties to resolve in the coming months including full monsoon out-turn and persistence of inflationary pressures, possible Federal Reserve action on interest rate hike, and the consequences of Iran deal on global crude supply and prices. 

But despite inflationary pressures growing sharply in protein-rich food items, RBI stated that several factors could have a ‘significant mitigating influence’ on future inflation numbers such as low crude prices, increase in planting of pulses and oil-seeds, prospects of rainfall in August and September, government's current proactive supply management to contain shocks to food prices and finally its decision to keep increases in minimum support prices at moderate levels. 

Growth forecast for fiscal year 2016 unchanged at 7.6%....

The RBI assesses the growth outlook to be improving gradually and hence retained the growth forecast of 7.6% for the fiscal year ending March 2016. This seems largely based on some signs of improvements in urban consumption, particularly auto sales and a good monsoon that is expected to boost rural output and incomes, and low commodity prices that is likely to lift overall consumption in the economy. 

But the central bank sounded a cautious note on supply constraints and exports. Notwithstanding some improvement in the state of stalled projects, supply constraints continue to be binding and new investment demand emanating from the private sector and the central Government remains subdued. In addition, export contraction could become a prolonged drag on growth going forward in view of sluggishness in the global economy.

Limited transmission of past rate cuts, loan demand to pick up in the third quarter….

The Governor reiterated his message to banks who have been unwilling to reduce lending rates, arguing that since the first rate cut in January, the median base lending rates of commercial banks have fallen by approximately 0.3%, which is a fraction of the 0.75% in rate cut so far. Consequently, the lack of the trickle-down has had limited benefits for the economy. 

At the same time, the RBI recognizes that part of the problem is the vicious cycle of non-performance in industries and the large debt burden it is saddled with, and the rising bad loans in the banking system. Indebted companies, therefore, argue that the central bank should take comfort in the fall in wholesale price inflation for an unprecedented eight months and cut interest rates further, but to no avail. Instead the central bank, expecting loan demand to pick up in the third quarter of current fiscal year, has advised commercial banks to cut lending rates further to secure new lending.

Key takeaways

• The central bank is cognizant of the recent inflationary pressures and has taken into account, both, concerns as well as factors that may potentially offset these concerns. Given that it has reduced its forward inflation forecast, it believes that the prices will soften in coming months.

• The RBI also stated that it will monitor developments to identify emerging room for further monetary easing. Therefore, taking into account RBI’s comfort range on real rates at 1.5-2% and the mitigating influence of several stated factors are expected to keep CPI inflation below the January 2016 target of 6%, we can expect a further 0.25% easing this fiscal. 

• Though the balanced approach and dashing of expectations with respect to an imminent hike in foreign investment limits did not cheer the market, the rupee strengthened in the intra-day trading against the dollar. The RBI and government are believed to be working on an institutional framework wherein limits will be increased by a quantum based on foreign investors’ share in the market and the setting is expected to happen twice a year. The Governor’s statement that the next round of limit review will factor in potential volatility around Fed and domestic liquidity (i.e. during October-December) has poured cold water on market’s expectation. 

• The RBI's next policy review is set for September 29, after the Fed’s meeting. The market expects that an increase in US interest rate will suck money out of emerging markets. Not surprising that the central bank has decided to maintain a status quo to gauge the potential impact and volatility in the foreign exchange market before finalizing its own stance.