Rockstar Rajan's first rate cut: Decoding the surprise element

Raghuram Rajan has always had a penchant for springing surprises.

That was quite evident from his first day in office as central bank governor in September 2013, when he almost announced a full monetary policy instead of the customary, short remarks a newly appointed governor would typically do.

When Rajan announced a earlier-than-expected rate cut by quarter percentage point on Thursday, the same surprise element was evident, but only with respect to the timing of the cut.

With both retail and wholesale inflation following the path envisaged by Urjit Patel panel, everyone was expecting a rate cut. The only question was whether that would come in the February policy or post budget.

A section of the economists were expecting the rate cut to happen by March-April when the government unveils the budget and inflation pattern pans out in the absence of favourable base effect.

“The timing came as a bit of surprise since, based on the RBI’s earlier statements, we were expecting the rate cut to happen by end of fiscal,” DK Joshi, chief economist at Crisil ratings said.

But, to be sure, in the December policy, Rajan had left enough indications that he would go for a rate even outside the policy cycle if inflation sticks to the expected course.

“If the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle,” Rajan had said.

But the clamour for a rate cut was getting louder and louder and the central bank has been under tremendous pressure to lower rates.

Those argued in favour of a rate cut point out the steady decline in the CPI inflation, the key price indicator for the central bank for policy formulation, over the past few months.

An expert panel under RBI deputy governor Urjit Patel had targeted 8 percent CPI in January 2015 and 6 percent a year later. Inflation has already fallen way below these estimates.

In that sense, the retail inflation has excelled the expectations of the RBI by dropping below 6 percent in three consecutive months, thus obliging to the central bank’s glide path.

On the other hand, the demand for a rate cut is intense in the face of faltering corporate growth. Lower borrowing costs can certainly give a push to companies, as well as consumers.

The unexpected cut in the repo rate, or the key lending rate, to 7.75 percent, marks the first rate cut in Rajan’s tenure. This is likely to be followed with another 25 to 50 basis points (bps) cut during the course of the year.

One bps is one hundredth of a percentage point.

The rate cut will prompt banks to lower their lending rates. Most banks have already cut their deposit rates and a policy signal from the central bank, is enough to trigger the a southward movement in bank lending rates.

Even though the 25 bps rate cut wouldn’t significantly add to the growth, it could boost the sentiments, Joshi said.

Going by the past comments of the central bank, the timing of Thursday’s rate cut is surprising for the following reasons:

First, some economists expect an early rate cut could tantamount to lowering the guard before the battle is over for Raghuram Rajan.

The former economist had made his idea of fighting inflation clear several times in the past, saying he wants finish the fight for once and for all and explained why one shouldn’t get swayed by the inflation data for a month or two. Inflation has begun falling to below 6 percent only in the recent months.

Two, Rajan had time and again stressed the importance of reciprocity from the fiscal authorities to complement the efforts put in by the monetary policy to set things right in the economy.

The Union Budget, likely to be announced by end-February, would have given a clearer idea to the central bank about the fiscal side and then chart the course on interest rates.

Third, one major reason for the big fall in CPI numbers in October (5.52 percent) and November (4.38 percent) is the high base effect of last year. A higher base in the corresponding period in the previous year will result in a lower number this year, even if the quantum of growth is same. In October and November of 2013, CPI inflation numbers stood in double digits, 10.09 percent and 11.16 percent, respectively.

The high base began fading in December as in the corresponding period in 2013, CPI fell to 9.87 percent. This has somewhat reflected in the December 2014 CPI numbers, which inched up to 5 percent. Going ahead, the benefit of base effect will vanish further.

Fourth, the food inflation has actually risen to 4.78 percent in December from 3.14 percent in November. Food prices typically ease in winter but moves north as summer approaches. Food inflation is a bigger concern for the central bank, as it has stressed all along in the past.

On Wednesday, the wholesale price index (WPI)-based inflation data for December showed that food inflation actually rose to 5.2 per cent from 0.63 per cent in the preceding month.

Prima facie, it appears that more than the decline in inflation numbers, Thursday’s rate cut appears to have come from the bigger concern of the government with respect to a prolonged slowdown in the economy.

Rajan has been under pressure both from the government and industries to go for an early rate cut.

“I’m a bit surprised with the timing of the rate cut,” said Madan Sabnavis, chief economist at Care rating. “But monetary policy works better when it comes as a surprise, " Sabnavis said.

Rajan, indeed, believes in surprises.