Two reasons why Raghuram Rajan will not cut policy rate today

The Reserve Bank of India (RBI) is set to announce its fourth bi-monthly monetary policy, later in the day, at 11 am, but in all likelihood, will be a non-event for financial markets since the central bank is unlikely to tinker with its key lending rate, repo rate, in the backdrop of high inflation, especially in the prices of food items.

The RBI, however, may opt to lower the statutory liquidity ratio (SLR), the portion of funds banks need to invest in government bonds, by another half percentage point in line with its stated strategy. This would follow the cuts in June and August.

Lowering SLR will, theoretically, make more liquidity availabile to banks, but may not immediately result in higher credit growth to the private sector since the loan demand is yet to pick up in a slow economy.

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An SLR cut will be part of a larger strategy to take the banking system out of financial repression, or forced investment in government bonds, denying money to the private sector.

Of the seven times Rajan has presided over the monetary policy, the repo rate, at which RBI lends short-term funds to banks, has been hiked by 75 basis points (bps) to fight inflation. One bps is one hundredth of a percentage point.

Already, banks are holding SLR much above the mandatory minimum at an average 28 percent as on July. Since Rajan took over as RBI governor, the SLR has been cut twice by a total of one percentage point.

Here are the two factors that the central bank might factor in while formulating its policy stance:

For one, although both the consumer price index (CPI) inflation and the wholesale price index (WPI) have shown signs of easing in recent months, the central bank might not be convinced about the nature of the decline.

The WPI inflation fell to 3.74 percent in August from 5.19 percent in July, the lowest level in five years.

Retail inflation, important in the central bank’s scheme of things, also marginally fell to 7.8 percent in August from 7.96 percent in July but food inflation, a major concern for the central bank, hardened to 9.42 percent from 9.36 percent a month ago.

The stubbornness in food inflation was primarily due to a 15.15 percent jump in vegetable prices and 24.27 percent jump in the fruit prices, putting pressure on overall price levels.

Secondly, the central bank will also take into account the possibility of increase in fuel prices arising out of the fresh coal scenario and new gas pricing. As _Firstbiz_ pointed out earlier , the result of new coal allocation policy and gas pricing formula couldbe a possible increase in energy prices forconsumers.

The central bank, which has openly declared battle against retail inflation, won’t take the chance of ignoring signals that could result in an upward pressure on inflation.

The RBI has reiterated its target to bring down retail inflation to 8 percent by January 2015 and to 6 percent a year later, in keeping with the the recommendations of the Urjit Patel committee.

Going by the current indications, a rate cut mayhappen sometime next yearand the good news is that it couldeven happen beforeJanuary 2016.