RBI unlikely to oblige with a rate cut today. Status-quo will do more good to economy

Amid mounting pressure on him to begin the rate easing cycle, Reserve Bank of India (RBI) governor Raghuram Rajan will announce his fifth bi-monthly review of monetary policy on Tuesday.

Ahead of the policy, finance minister Arun Jaitley met Rajan on Monday to make a case for a cut in the key lending rate of the central bank, or repo rate, to prop up growth in Asia’s third largest economy.

Those who argue for a rate cut cites a rapidly falling inflation and weak economic growth as main reasons. Prolonged slowdown in economic activities has indeed resulted in a near-absence of bank loan demand from medium- and large-sized corporations. India’s economic growth slowed to 5.3 percent in the September quarter from 5.7 percent in the June quarter.

The retail inflation, which the RBI has accepted as its key price indicator for monetary policy formulation, has eased to 5.52 percent in October from 10.09 percent a year ago. The RBI has an initial target of 8 percent retail inflation in this January and 6 percent a year later.

Will Rajan oblige this time with a surprise rate cut? Quite unlikely.

Here are the logical reasons:

For one, despite the fall in retail inflation numbers in the recent months, the central bank would want to have a certainty that the easing sustains from here onwards. Besides the decline in international oil prices and prices of vegetable and fruits in the domestic market, what has has contributed to the fall in inflation rate is a favourable base effect.

A higher base in the corresponding period in the previous year would show a lower inflation number this time around, even though the quantum of rise is identical. The rather unpleasant fact is that the benefit of base effect will somewhat vanish from December since inflation had begun declining from same period last year. In November 2013, the retail inflation stood at 11.16 percent, while the print has witnessed a decline in December to 9.87 percent. The figure has been on an almost steady decline ever since.

Two, time and again, the apex bank has stressed that it is critical to bring down inflation expectations of households, which are still high. The RBI’s inflation expectations survey for September 2014 showed that the proportion of respondents expecting general price level to rise by ‘more than the current rate’ has increased marginally as compared with the previous round of survey for both three-month ahead period and one-year ahead period.

The RBI would want to contain inflation expectations before lowering its guard against inflation.

Three, chances of a spike in the prices of vegetables and food items cannot be ruled out in the ensuing months in the backdrop of a not-so-good monsoon. A clearer picture will emerge only by March-April regarding the trend in the vegetable prices. For now, the path is still uncertain. Typically, vegetable prices tend to rise towards summer. Rajan would factor in this possibility.

Four, a token quarter percentage point rate cut would do no magic to revive growth as perceived by many since the slowdown in growth has more to do with investor sentiment than rate sentiment.

As bankers have pointed out loan demand has remain subdued as no new projects have come up in a meaningful manner. That is more because of structural bottlenecks - clearance delays, absence of fresh investments and existing stress on balance sheets.

Even if the RBI succumbs to the pressure and cuts rate by 0.25 percentage point, that is unlikely to result in any major change in the growth scenario.

Five, even if the RBI cuts rate, there is no assurance that banks will follow and do the same to their borrowers. Monetary transmission in the banking system following the RBI’s rate actions has been limited in recent years. Banks seldom take cues from the RBI’s actions to revise their interest rate structure and, instead, turn towards their on liquidity and demand scenarios to take a call on loan pricing.

Six, as Rajan has highlighted in the past the RBI’s intention is to hunt down inflation for ‘once and for all’. If the RBI lowers guard at this stage against inflation, while it is not fully convinced yet about a victory over inflation, the central bank may have to repent at a later stage when inflationary risks return to the economy.

Clearly, Rajan wouldn’t want such a situation.

The conclusion: It is unwise to expect a rate cut today. A status-quo in rates at this stage would do more good to the economy than harm.