Good reasons not to cut repo rate

The minutes of the Monetary Policy Committee (MPC) meeting of December 6 -7, released by the Reserve Bank of India as required on the fourteenth day after monetary policy is announced, provide some interesting insights into what prompted the decision to keep the policy repo rate unchanged, and also the road ahead.

All six members of the MPC had unanimously voted to keep the policy repo rate under the Liquidity Adjustment Facility (LAF) unchanged at 6.25 per cent in marked contrast to the expectations of the market in general and the banking sector in particular, of a reduction of 25 basis points.

The 10-page long minutes, which were released on December 21 by the RBI, cover the statement of each member of the MPC under subsection (11) of section 45ZL of the amended RBI Act.

A critical reading of the individual statements shows that the focus was on (a) downward inflexibility of Consumer Price Index (CPI) excluding food and fuel, the so-called core component of inflation, (b) dawdling transmission of the cumulative reduction in the recent past of 175 points of policy repo rate to the lending rate of banks, and (c) demand shocks/compressions arising out of uncertainties due to withdrawal of Specific Bank Notes (SBNs) impacting the outlook for economic growth.

The MPC members recognised the adverse impact of withdrawal of SBNs — the ₹500 and ₹1,000 notes which have been withdrawn — but opined that this will be transitory. On inflation, the voices are sharper and clearer, with one of the MPC members, Chetan Ghate, noting that his “paramount concern at this juncture has to do with the stickiness of inflation excluding food and fuel”. The concern was reiterated by MPC member Ravindra Dholakia, who noted that there was a “significant chance of the inflation rate exceeding the threshold in March 2017 and in June 2017” and an upside risk to the 5 per cent inflation trajectory for end-March 2017.

RBI Executive Director Michael Patra, also a member of the MPC, reinforced this by noting that “it is critical to stay focused on the inflation target of 5 per cent for Q4 of 2016-17”.

And Governor Urjit Patel himself mentioned that inflation excluding food and fuel remains sticky.

He expressed concerns on cost push inflation due to the Seventh Pay Commission award, implementation of GST, and hardening of crude prices.

According to him, “achieving the inflation target of 5 per cent in Q4 of 2016-17 and securing 4 per cent — the central point of notified the target rate — remains the primary objective”.

This analysis of the undercurrents of the inflation trajectory was clearly missing.

So-called market experts proffered simplistic arguments in their zeal to argue for a lowering of the policy repo rate.

Apart from flagging concerns on inflation, the central theme of the minutes is the lack of transmission of repo rate cuts to the credit market.

As Ghate noted: we have an “imperfect interest rate pass through”; despite a 175-basis point reduction in policy repo rate cut between January 2015 and November 2016, the reduction in the weighted average lending rate (WALR) up to September 2016 was only 71 basis points on the outstanding rupee loans.

The incongruity of banks asking for more cuts but transmitting none of the repo rate cuts already offered has been a concern for some time now. It was a concern Raghuram Rajan pointed to in a statement on August 9, 2016, where he said: “Despite easy liquidity, banks have passed past rate cuts into lending rates only modestly. Earlier, some bankers had said that it was the lack of liquidity that was holding rates high, now I hear from some that it is the fear of FCNR(B) redemption that is making them reluctant to cut rates. I have a suspicion that some new concern will crop up once the FCNR(B) redemption is behind us. We would be happy if there was more transmission.”

The effective transmission of monetary policy is critical to reinvigorating the real economy. The markets should appreciate that in the absence of this follow-thorough, repo rate cuts as an instrument will be rendered ineffective.

In light of this, it is important to examine the reasons for incomplete pass-through of the policy repo rate to the lending rate. Is it structural, cyclical or technical?

The impediments were examined by the Urjit Patel Committee of 2014, which pointed to mostly structural factors such as administered interest rates, rigidities in repricing of deposits, interest rate subventions, the coexistence of large informal finance, fiscal dominance through statutory pre-emptions and asset quality.

Recognising this, the RBI and the Government have taken some initiatives to incentivise banks to improve transmission at their end. These include reform measures on small savings to make the rates market-related rather than administered, the RBI’s guidelines to the banks to adopt marginal cost lending rate (MCLR), and a gradual reduction in statutory liquidity ratio (SLR).

Since structural rigidities have been addressed at least in some measure, it would be reasonable to expect banks to now become proactive in cutting lending rates rather than asking for more repo policy rate cuts. But banks themselves have been caught in a vortex of uncertainty and weak business sentiment following the sudden withdrawal of SBNs.

Today, there is lack of clarity on the road ahead and this in itself is a stumbling block to proactively cutting rates. While this may be transitory, the duration of this transition remains an unanswered question.

Given this complex situation, the wait and watch policy is likely to continue and a policy repo rate cut will likely be on hold for some time now.

Pattnaik is Professor, SPJIMR. Rattanani is Editor, SPJIMR. Through The Billion Press

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