Policy Pulse | Why RBI is set to cut interest rates

Tulsi Jayakumar

What is in store for the industry in the first monetary policy review after the election results? Can Corporate India expect a hat-trick from the Reserve Bank of India (RBI) in terms of rate cuts?

The relationship between the RBI and the government remained contentious through much of the period during the government’s previous stint, which culminated in the resignation of then Governor Urjit Patel. The Monetary Policy Committee (MPC), headed by Governor Shaktikanta Das, cut the policy repo rate twice in a row in 2019.

In February and again in April, the MPC voted by a 4/2 majority in favour of reducing the policy repo rate by 25 basis points each. Consequently, the repo rate under the Liquidity Adjustment Facility (LAF) was brought down by 25 basis points to 6.25 percent in February 2019 from 6.5 per cent, and then further to 6 percent in April.

With an LAF corridor width of 50 basis points, the reverse repo rate and the Marginal Standing Facility (MSF) currently stand at 5.75 per cent and 6.25 percent, respectively. Further, the MPC decided to change the monetary policy stance from calibrated tightening to neutral in February, which was maintained in April.

So, will the RBI cut interest rates for the third time this year? And what will be the monetary policy stance?

The RBI in its decision will be driven by the assessment of both domestic and global developments. Domestically, the monthly report of the Ministry of Finance, released on May 1, indicates a decline in the real GDP growth further from the levels in Q3 2018-19 to less than 6.5 per cent. The estimates of national income for 2018-19 released by the Central Statistical Office (CSO) show that the economy slowed down further.

The deceleration in economic activity for the fourth consecutive quarter in 2018-19 to the level which is the lowest in the last five years can be explained by the slowdown in consumption over the past two years, especially in the March quarter. This was reflected in declining two-wheeler sales and auto sales in general, which are considered as lead economic indicators.

Other lead indicators such as the Purchase Managers Index (PMI), the Index of Industrial Production (IIP) and the infrastructure index also slowed. The reduction in the real growth rate of imports to under 5 percent in February, from about 40 percent in April 2017,  has been indicative of a decline in the real GDP growth as well. At the same time, the fixed investment rate as a percentage of GDP — the true indicator of investments in the economy — may get affected further as the slowdown in the growth of non-food bank credit indicates.

The government’s fiscal situation continues to be challenging as revenue expenditure has been higher in recent months.

On the inflation front, headline inflation — measured using both consumer and wholesale price indices — declined in 2018-19. The headline CPI at 2.92 per cent, in particular, is low enough to provide headspace for a rate cut in the second bi-monthly monetary policy review of 2018-19. Three constituents of the food group—fruits, pulses and sugar—were in deflation while inflation in milk and products, and oils and fats was also subdued.

Also, global demand continues to remain weak. The Chinese economy grew 6.4 percent in the March quarter while the GDP growth in the US was at an annual average rate of 3.2 percent in the first quarter of 2019. The US-China trade war and the tariffs imposed on each other are likely to result in decline in growth in both countries.

Yield curve inversion, as has been witnessed in the US bond markets last month— a key relationship between the 3-month bill and a 10-year note inverted by 14 basis points—is said to be a reliable recession indicator, historically. These would indicate the possibility of a Fed rate cut later in the year.

Against the backdrop of such domestic and global developments, it seems highly likely that we may witness a policy rate cut in the upcoming monetary policy review to be announced on June 6. This would also be in line with the expectations of the government, which has been voted in with a massive mandate. How effective such a rate cut would be in bringing about the desired increases in private investment, however, remains to be seen.

(Tulsi Jayakumar is professor of economics at S.P. Jain Institute of Management & Research, Mumbai. Views are personal.)