What’s behind the RBI’s rate cut?

Progress is impossible without change; and those who cannot change their minds cannot change anything – George Bernard Shaw

The Monetary Policy Committee’s (MPC) stance has come a full circle since it declared “calibrated tightening” in its October 2018 policy and stated that interest rate cuts were ‘off the table’.

Since then, it reduced the key policy rates twice in three announcements.

Repo rates take a U-turn…

This time, the repo rate was cut by 25 bps from 6.25% to 6.00% and consequently, the reverse repo rate stands adjusted to 5.75%.

 So what made the RBI change its mind?

When the MPC recommended calibrated tightening, crude oil prices were peaking and the rupee was dropping sharply. At the same time GDP growth was riding high.

Things have changed considerably since then.

Here’s how the MPC sees the economy now…

GDP growth for FY19 is expected at ~7%, as domestic economic activity decelerated. The MPC attributed this to a slowdown in consumption, both public and private. However, the RBI projects that it will be 7.2% in FY20.

Exports growth remained weak in Jan and Feb 2019 and correspondingly, the trade deficit narrowed down to its lowest level in 17 months.

The MPC also noted that CPI inflation has finally moved up to 2.6% in February 2019 after four months of continuous decline. Its revised estimates for CPI have dipped to 2.4% in Q4FY19 after which it expects inflation to climb to 2.9-3% in H1FY20 and 3.5-3.8% in H2FY20.

The policy concluded, “The need is to strengthen domestic growth impulses by spurring private investment which has remained sluggish.”

Translated into simple English, this means we need to lower interest rates to boost growth.

Industry and corporate indicators also prompted lower rates…

• Crude oil prices have risen on production cuts by OPEC and Russia as well as disruption in supplies due to US sanctions on exports from Venezuela. A lower interest regime would give corporates and consumers some respite.
• Sales of commercial vehicles contracted during February. Other indicators of the transportation sector, viz., port freight traffic and international air freight traffic, also contracted. Here again, cutting rates could help revive these baseline indicators of the economy’s health.
• The growth of eight core industries remained sluggish in February. The manufacturing component of the index of industrial production (IIP) growth slowed down to 1.3 per cent in January 2019 due to slower growth of automobiles, pharmaceuticals, and machinery and equipment. Capacity utilization (CU) in the manufacturing sector, however, as measured by the Reserve Bank’s order books, inventory and capacity utilization survey, improved to 75.9% in Q3 from 74.8% in Q2 exceeding its long-term average. Lower rates could trigger some fresh action in Capex as capacity utilization rates head for their zenith.
• Firms participating in the Reserve Bank’s industrial outlook survey of manufacturing companies reported a reduction in input price pressures, but they expected an increase in staff expenses in Q1:2019-20.

And the bottom line is?

A situation of sluggish business activity coupled with low inflation is a textbook scenario for interest rate cuts.

However, the proof of the pudding is in the eating.

So, the great question that plagues the RBI, businesses and consumers is: How soon and by how much will policy rate cuts get translated into lower lending rates?