What RBI repo rate cut means for India and Urjit Patel

When it comes to the central bank's communications, nuances do matter.

 |  6-minute read |   05-10-2016
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In line with the latest policy measures, interest rate decisions will now be taken by the Monetary Policy Committee (MPC) and RBI governor Urjit Patel's own role in rate setting will be limited. But there is more to it in a rarefied environment of central banking, as felt by many experts.

The decision is felt almost as important as how and what he communicates. Whether he will take pains to dilate on the rationale of the central bank's Policy stand and explain the macro fundamentals governing the present policy stance and economic outlook are eagerly asked questions.

Let us move on to see more of the answers to them now. The MPC decided at its first policy review meeting that lasted one-and-a-half days to reduce the benchmark repurchase rate (repo and reverse repo rates) by 25bps/0.25 per cent to 6.25 per cent on Tuesday. The RBI's key policy uniform rate has now been cut to its lowest levels since the year 2011.

The decision of the MPC reflects the accommodative Monetary Policy stance in time with the objective of achieving CPI inflation at five per cent by Q4 of 2016-17, the central bank said in its statement, which is very important. Retail inflation dropped to the five-month low of 5.05 per cent in August.

Governor Urjit Patel, in a press meet after the announcement of the rate revision by the RBI, briefed the media for the first time after his elevation without giving any hint on what the committee's future stance on interest rates could be.

However, the neutral rate is 1.25 per cent now, which is lower than the 1.5-2 per cent regime that prevailed under Raghuram Rajan, the previous governor. The neutral rate is the rate of interest a saver or lender receives after allowing for inflation - also the gap between the risk-free rate and the inflation - which is supposed to be a big determinant of the policy rate.

By putting two and two together, we find that interest rates will ease further in the next policy review, in December. But then that is only a conjecture in view of the restricted and implicit speech of Patel.

What has been on watch is the language of the policy statement, the extent of consensus in the committee and the manner in which the RBI governor Urjit Patel presents the central bank's position.

Why is it that important when the decision is made public any way? Because, when it comes to the central bank's communications, nuances do matter. Post the global financial crisis, communication itself had turned a tool rather than acting as a tool.

Over the year, expansive to mealy-mounted approaches have been followed by the central bank Heads. Unless the policy stance of the RBI is explained with a whole host of issues involved, the markets won't know how to react.

Given that so little is known about the liquidity stance of the RBI under the earlier regime, no one can say how much of it was driven by Rajan or Patel himself as a man behind the Monetary Policy Frame work (MPF) and as also the maker of the policy - shift from the governor announcing the rate decisions to a six-member panel henceforth.

However, the policy statement of Urjit Patel would be useful to gauge the future market conditions, the rate dependent outcomes such as wholesale and retail price index and inflation rates and growth trends.

Articulating the main concern that informed the newly constituted rate setting panel, Patel said the global demand environment was clearly looking weak- far weaker than expected.

With the forecast for world economic growth to be on the down trend, the MPC has opted to lay primacy on "supporting growth" while keeping its eyes firmly fixed on the central remit to target medium term retail inflation objective within the band width of plus or minus two percent around the four percent target rate.

The lucidity of the policy statement shows a great deal of consensus largely dovish though. The full text is expected to be ready only on October 18.

The decision, however, reflects concern over risks to growth from global uncertainty and volatility in global financial markets especially ahead of the US Presidential elections.

Even as improvement in the outlook for food inflation is expected in the background of increased acreage of cultivation of pulses, food crops and vegetables, supply chain and storage facilities management measures in place, MPC is still cautious in flagging the risks to the trajectory of price gains.

In the panel's estimation, higher home rent, allowances and increase in minimum wages from 7th Pay Commission and minimum support prices, could contribute to a fresh "cost spiral".

Multiple factors however auger well for the outlook for both the industrial and service sectors, including the new GST tax regime but only in the medium to long term.

But the worsening trade demand (internal and external) could offset the gross value added (GVA) momentum, the MPC noted, while retaining RBI's GVA growth forecast at 7.6 per cent.

The market reaction to the policy has been muted with the 10-year benchmark remaining relatively unchanged from yesterday's level. The bond market had rallied sharply over the past quarter in anticipation of the rate cut - for example, the benchmark 10y yield dropped 60 basis points from 7.5 per cent to 6.9 per cent since late June.

The BSE Sensex climbed 0.32 per cent to 28,333.55 points and yield on the benchmark bond fell six basis points to 6.72 per cent, reflecting optimism that further rate cuts are on the medium term horizon. The rupee strengthened 0.18 per cent to Rs 66.46 per dollar.

Short to medium term government securities have seen yields dropping in response to the policy rate cut. The outperformance of shorter bonds over long bonds is a characteristic of late stages of rate cut cycles.

The shorter segments are more sensitive to rate cuts and liquidity infusion in comparison to the long end, which is more sensitive to emerging macro developments. Going forward we expect the markets to watch CPI points to see if inflation follows the expected downward trajectory over the coming several months.

The government said the move would help boost growth and improve market sentiment. We welcome the announcement by the RBI said finance secretary Ashok Lavasa. The decision reflects a wide ranging opinion, consultative process and is in keeping with general developments of the economy.

That the panel has given a decisive start to the rate setting process through deliberations and consensus is beyond doubt. But how it weathers the internal and external challenges, should they arise, remains to be seen.

Writer

K Srinivasan K Srinivasan @krishsri59

The author is a GST reader and writes on macroeconomics and indirect tax laws.

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