Subbarao's Surprise: A 50 bps cut, but expect no more

It turns out that Reserve Bank of India Governor Duvvuri Subbarao is quite the master of surprises. He did surprise the markets with a deep 75 basis points cash reserve ratio (CRR) cut on 9 March, a week before the budget, and he has done it again, this time by cutting the signal repo rate - the rate at which RBI lends short-term funds to banks - by a higher-than-expected 50 basis points.

Most analysts and policywatchers expected a 25 bps token rate cut, given the fact that inflationary pressures were still elevated and the RBI’s own macroeconomic review for 2011-12, released a day earlier, had pointed to inflation remaining ‘sticky’ in FY13 as well.

However, by cutting the repo rate by 50 bps, Subbarao has put concerns over slowing growth above inflation management this time, indicating that the government’s concerns too have been heeded. Finance ministry officials have, for some time now, been indicating the need to bring down interest rates to get the growth momentum back on track, but RBI has been putting that off as inflation has remained sticky all through.

Even a day before the RBI unveiled its Monetary Policy Statement for 2012-13, the wholesale price index (WPI) number came in at 6.89 percent for March, down only marginally from 6.95 percent a month ago. The Index of Industrial Production (IIP) number, on the other hand, came in last week at just 4.1 percent for February 2012.

So what does Subbarao’s move indicate? Says Subbarao in his policy statement: “..Non-food manufactured products inflation is expected to remain contained reflecting the lagged effect of past monetary policy tightening on aggregate demand. Corporate performance numbers also indicate that the pricing power has reduced. Consequently, the risk of adjustments in administered prices translating into generalised inflationary pressuresremains limited, though there is no room for complacency.”

Inflation, RBI said, was broadly in line with the central bank’s projections for 2011-12, and even the March 2012 number of 6.9 percent was in line with the RBI’s 7 percent estimate.

Important to note, despite the 50 bps rate cut, however, is RBI’s caveat on growth and the trend rate. Says the policy: “An important issue in this regard is the economy’s trend rate of growth,_i.e.,_the rate that can be sustained over longer periods without engendering demand-side inflationary pressures. Recent growth and inflation patterns suggest that the trend rate of growth has declined from its pre-crisis peak. Even though growth has fallen significantly in the past three quarters, our projections suggest that the economy will revert close to its post-crisis trend growth in 2012-13, which does not leave much room for monetary policy easing without aggravating inflation risks.”

A clear indication from the central bank that, given the contextual requirement of the present time, a 50 bps rate cut may have been effected, but expecting similar rate actions going forward may not be appropriate since the trend growth rate may stoke inflationary risks all over again. But on current assessment, the RBI says the economy is clearly operating below its post-crisis trend.

The policy, therefore, is aimed at doing three things: adjusting policy rates to levels consistent with the current growth moderation, guarding against risks of demand-led inflationary pressures re-emerging and providing a greater liquidity cushion to the financial system. To provide the liquidity cushion, the RBI has raised the borrowing limit of scheduled commercial banks under the marginal standing facility (MSF) from 1 per cent to 2 per cent of their net demand and time liabilities (NDTL) outstanding at the end of second preceding fortnight with immediate effect.

The CRR, however, has been left unchanged after that deep cut of March.

That Subbarao has heeded the pleas from the corporate sector and the ministry of finance for now is clear, but the RBI governor is not known to mince his words. His guidance for the future, therefore, is quite explicit: the repo rate cut was based on the current situation, and does not necessarily mean more than that. Not for now at least.

Says Subbarao: “The reduction in the repo rate is based on an assessment of growth having slowed below its post-crisis trend rate which, in turn, is contributing to a moderation in core inflation. However, it must be emphasised that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates.” Clear enough indication of what Subbarao’s stance is.

And for Finance Minister Pranab Mukherjee, who hinted earlier in the day that the RBI may reverse the monetary policy stance, Subbarao continues to have significant words of advice. “The fiscal slippage in 2011-12 was also significantly high. Even though the Union Budget envisages a reduction in the fiscal deficit in 2012-13, several upside risks to the budgeted fiscal deficit remain,” he says.

“In particular, containment of non-plan expenditure within the budget estimates for 2012-13 is contingent upon the Government’s ability to adhere to its commitment of capping subsidies. Going by the recent burden-sharing arrangements with the oil marketing companies (OMCs), the budget estimate of compensation for under-recoveries of OMCs at the present level of international crude prices is likely to fall significantly short of the required amount. Any slippage in the fiscal deficit will have implications for inflation,” the RBI governor adds in the policy statement.

The question most policywatchers, including former RBI Governor Bimal Jalan, are asking is, how much can monetary policy alone do to rein in inflation and kickstart growth?

Subbarao, it seems, has done more than his share this time.