Monetary Policy | RBI pause is puzzling, but a rate cut is not far away

Mint Road seems worried enough on inflation to look past four quarters of material decline in economic growth.

Or is it about waiting for the Union Budget to understand what would be the nature and impact of possible counter-cyclical measures to support growth?

To be sure, inflation expectations have been rising. Incipient inflation risk emanates from certain food items, and the recent revision in telecom tariffs should also put upward pressure in coming months.

Indeed, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) expects consumer price inflation to stay above its comfort zone of 4 percent up to the second quarter of the next fiscal.

But the MPC has continued with its accommodative stance, which means it can cut the repo rate if conditions so warrant.

We believe that there will be opportunities to do so because inflation could decline in a few months. Also, since the recovery will be gradual and the economy is likely to grow below potential over the next few quarters, the MPC tilt could be towards a rate cut.

The MPC’s decision to “pause at this juncture” also highlights another concern – delayed transmission of past rate cuts into the credit market, specifically bank lending rates. It acknowledges that transmission has improved, but there is scope for much more.

Easier monetary policy of the past few quarters has not propelled economic activity so far. Bank credit growth remains weak at nearly 8 percent in November, much lower than 14.9 percent a year ago.

In particular, bank lending rates based on the marginal cost of funds have only come down 44-49 basis points (bps) despite a cumulative repo rate reduction of 135 bps. This has reduced the effectiveness of monetary policy in stoking growth.

In contrast, market-determined interest rates such as the yield on the 10-year benchmark government security have fallen more than 100 bps.

Besides weaker domestic demand, such stickiness in bank lending rates can be cited as a factor hampering credit offtake. On their part, banks, driven by risk aversion, are also going slow on lending and deploying most of their funds in government securities.

The stickiness in bank lending rates also reflects high cost of funds. Typically, in an easing environment, deposit rates closely follow the repo rate. Deposits are the main source of funds for banks. So, a fall in deposit rates creates room to lower lending rates. But in this cycle, deposit rates have come down by less than 50 bps – a fraction of the fall in repo.

But the stick in the mud is the small-savings rate, which are not only higher on average compared with fiscal 2019, but also significantly above deposit rates offered by banks. For instance, a 5-year small savings deposit yields 7.7 percent whereas a bank deposit with similar maturity yields 6.3 percent on average.

This underscores the need to free small-savings rates – something the MPC said, too.

Some reduction in small savings rates is expected for the next quarter, but looking at past revisions, it seems unlikely that the rates will see a major correction. Moreover, small savings do help fund the Centre’s fiscal deficit. Inflows under these instruments have jumped nearly 24 percent during April to October this fiscal, which is more than 15 percent growth during the same period last fiscal.

All that builds up pressure to ensure monetary policy effectiveness through better transmission of rate cuts.

On its part, the RBI has mandated banks to link their lending rates to an external benchmark. This is different from the current practice of basing lending rates on conditions endogenous to banks.

While that is expected to speed up transmission, high small savings rates will continue to be a structural curb on such efforts.