The benign turn in the macro economy in recent months has provided policy space for the RBI to cut rates, as was widely expected. After recording 8.1 per cent in September 2012, the WPI inflation had started to trend down and reached 7.18 per cent by December 2012.

More importantly, core inflation, which is a gauge of demand pressures in the economy, has been declining steadily from 7.99 per cent in December 2011 to 4.19 per cent in December 2012. Against this backdrop, the RBI has cut its March 2013 inflation projection to 6.5 per cent from 7.5 per cent projected in October 2012 and has talked about ‘space for monetary policy to give greater emphasis to growth risks’. Revision in GDP growth target from 5.8 per cent to 5.5 per cent for FY’13 was expected as it is in line with the domestic and global economic situation.

At the same time, inflation concerns have not gone away as food inflation remains in double digits and inflation from fuel items (coal and electricity prices could be revised up even as global crude prices remain edgy) could also add to inflationary pressures, but it is important to anchor inflation expectations. Though inflation has softened, overall inflation will remain range-bound, limiting the scope for sharp cuts, going forward.

Spotlight on growth

In the growth-inflation dynamic, the spotlight has clearly turned on growth and with inflation softening and growth weakening, the RBI’s policy is growth-supportive. After the 50 bps cut in Repo rate in April 2012, it is only now that a small rate cut (25 bps) has been announced. The continuing weakness in investment, particularly the 11.1 per cent contraction in capital goods production in the current year so far (April-December 12), has hurt the outlook for industry as industrial production rose by only 1 per cent in the same period against 3.8 per cent IIP growth a year ago. The immediate impact of the RBI’s action will be to lift sentiment. The softening in rates may not lead to any immediate rush for investment, but seen in the context of reform measures announced by the Government, the step is supportive of investment, going forward.

The pressure on system liquidity should ease somewhat with the 25 bps cut in CRR, which will impact monetary transmission as it injects primary liquidity of Rs 18,000 crore into the economy and reduces the cost of funds for banks.

The RBI’s non-food credit growth target for March 2013 has been retained at 16 per cent and appears to be achievable given the 16.2 per cent year-on-year (yoy) growth till January 11, 2013. The aggregate deposits growth target has also been kept unchanged at 15.0 per cent, though this may be difficult to achieve, considering the 13.3 per cent yoy growth till January 11, 2013.

However, due to slowdown in deposit growth of banks, the RBI cut the M3 growth target from 15 per cent to 14 per cent in July and again to 13 per cent on January 29, 2013. With Government spending on hold to help achieve the FY13 fiscal deficit target of 5.3 per cent, perhaps system liquidity could remain tight, prompting the RBI to intervene through more open market operations (OMOs).

Bigger cut desirable

While banks are likely to cut lending rates and effect policy transmission, some cut on deposit rates also may be required to protect margins of banks, though, considering the nine-year-low deposit growth, this may be a tough call.

The 25 bps cut in Repo and CRR was expected, given the movement in macro parameters. But perhaps the RBI could have gone in for a bigger 50 bps cut as the sentiment needs a big boost and investment also needs to pick up significantly, going forward. Overall, however, this is a step in the right direction and marks the start of a rate-cutting cycle.

(The author is Head, Economic Research, State Bank of India).

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