The Monetary Policy Committee (MPC) of the RBI cut the Repo rate today by 25 bps from 6.25% to 6%. A Repo rate cut was widely expected, and rightly so this time.
Important to understand WHEN the RBI cuts rates
Sometimes market players/watchers predict rate cuts simply because growth slows, forgetting that RBI’s primary mandate is to keep CPI inflation within its target range of 4 +- 2% or 2-6% in the medium/long term. Simply because inflation is within this target range at the current moment doesn’t imply that the RBI will cut. The MPC usually looks at its projections for inflation 3-4 quarters out. If inflation looks close to its 4% (average) target or lower, without any significant risks to the upside, then it considers cutting rates.
Market players always tend to advocate for a Rate cut
It’s important to remember that while the Central Bank will always tend to follow a cautious approach, market players (banks, research houses, financial institutions, corporates) will always tend to advocate for rate cuts. Why? Because lower interest rates are a positive driver for all of them.
1) Banks can offer lower rates on deposits when the Repo rate falls and the RBI signals a low interest rate environment. This allows them to lend at lower rates to borrowers, which can help stimulate credit supply and expand banks’ loan books and profits.
2) Research houses are usually attached to the equities business. A Repo rate cut usually transmits through the banking/financial system and results in lower lending rates. This means that listed companies can borrow at lower interest rates, which is obviously a positive for them/equities in general. Also, for listed companies that have existing floating rate loans, a Repo rate cut usually translates into a fall in interest rate payments. Given this favourable impact on equities, research houses will usually tend to root for rate cuts.
3) Corporates (listed or unlisted) want rate cuts for the same reason listed in point no. 2 above.
CPI inflation has been consistently lower than RBI’s estimates over the last few months and some of the upside risks have receded. Hence the RBI felt comfortable cutting.
Even though CPI inflation has stayed below the mid-point of RBI’s target range (4%) since Nov ’16, RBI kept the Repo rate unchanged at 6.25% because it was unclear about the inflation trajectory going forward and there were risks to the upside - potentially weak monsoon, Fed rate hikes, GST implementation, global uncertainties (read Trump), oil price trajectory, fiscal slippages due to farm loan waivers, disbursement of allowances under the 7th pay commission etc.
However, over the last few months, inflation has been consistently lower than the market’s and RBI’s estimates. Also, many of the upside risks to inflation have receded (monsoon has been normal, GST implementation has been smoother than expected, Fed hikes have been priced in, oil prices have been benign).
The RBI now expects headline inflation (the total CPI inflation number reported by MOSPI) to be a little above 4% by Q4 excluding the impact of implementation of House Rent Allowance (HRA) recommendations under the 7th Pay Commission. This is lower than RBI’s June projections. As a result, the MPC felt comfortable lowering the Repo rate by 25 bps.
Monetary policy stance is still neutral. Some disappointed, but this is in-line with RBI’s usual approach.
The RBI continued to keep its monetary policy stance as “neutral” since it believes that inflation is headed higher from current multi-year lows. It will watch how things shake out and look at more data before and if it makes any changes to its stance. This was disappointing for some market players who were hoping for the RBI to signal towards a more “accommodative” stance (i.e. intent to cut rates further). However, this was a naïve assumption in my view. Given RBI’s central mandate (keeping inflation in range) and its widely known (and appreciated) conservative approach, I expected the MPC to remain non-committal about future rate trajectory.
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