By Snigdha Kalra
The Reserve Bank of India (RBI) finally ended a six-month streak of unchanged policy rates with the announcement of a 25 basis points (bps) rate cut on the 2nd of August, in the bi-monthly meeting of its Monetary Policy Committee (MPC).
Repo rate has been cut from 6.25% to 6%, while reverse repo rate has been cut from 6% to 5.75%. In light of free-falling inflation rates and slowed down economic growth, this is a welcome move by the RBI. It has, however, decided to maintain a neutral policy stance, citing upside risks to inflation.
What that called for a rate cut
The RBI had retained its neutral stance in June, keeping rates unchanged for the fourth time in the bi-monthly meeting of MPC. RBI Governor Urjit Patel had then said that he wanted to ensure that inflation will remain subdued in the near future, as “premature action at this stage risks disruptive policy reversals later and the loss of credibility.” At that time, inflation had touched a record low of 1.54%. It hasn’t recovered much in the two months since, and a good Kharif harvest is only going to prevent the recovery further.
Industrial growth has also been slow since demand for investment plummeted post-demonetisation. The stress levels in balance sheets of banks as well as corporations, due to the combined effect of high NPAs and demonetisation, are unlikely to allow a spurt in industrial growth in the near future.
In such a situation, a rate cut by the RBI was clearly inevitable. Everyone was expecting and looking forward to it. And that is what the RBI did. The only problem is that the fall was a meagre 25bps.
Wary of the consequence
While a rate cut by the RBI has been in the offing for a few months now, it has been following a cautious approach. Falling fuel and food inflation and the non-realisation of much inflationary pressure, either due to the rolling out of GST or due to the House Rent Allowance (HRA) hike in the 7th pay commission of government, have ensured that inflation has remained well below the target of 4%.
The RBI believes that the fall in inflation rates may not be as durable as it seems, and they may bounce back in the near future. It is difficult to determine whether the fall is a result of major reforms like demonetization and GST, which led to disruptions, or whether it is structural and here to stay. This has led it to cut the rate by only 25bps, as well as decide to keep a neutral stance.
Bracing the impact
The most immediate impact of this rate cut will be a corresponding fall in lending rates by banks, which will spur investment. Along with this, the major step taken by State Bank of India (SBI) to cut rates on savings deposits by 50bps will lead the other banks to follow suit. Again, the overall impact will be a fall in lending rates, which will help in bringing industrial growth back on track.
Inflation rates may also start recovering, once growth picks up. However, there is the problem of upside risk to inflation. The policy statement said that if states implement a raise in salary and allowances, following in the Centre’s footsteps, headline inflation could rise by 100bps above the baseline of 4% over 18-24 months.
However, despite the expectations of a rise in headline inflation in the coming months, it may help to cut rates by another 25bps. This sentiment was also resonated by Ravindra Dholakia, member of MPC, who voted for a rate cut of 50bps. How the RBI handles the situation will depend on the aftereffects of this decision, which remain to be seen.
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