Clipped from: https://www.thehindubusinessline.com/opinion/rbi-cedes-to-rate-cut-demands-but-will-it-work/article69192601.ece
Rate easing will exacerbate inflation without addressing structural limits to growth
With its 25 basis points (bps) rate cut, the RBI has finally relented to the growing demand from quarters that viewed the earlier 6.5 per cent policy rate as being “very stressful”. It also relays the newfound perception that easing regulatory tightness will resuscitate growth. Banking on counter-cyclical accommodation to address structural growth impediments will likely be ineffectual, in our view
RBI onboards rate cut with a neutral stance: With the 25 bps repo rate cut to 6.25 per cent, the RBI finally relented to growing demand from the government that saw the central bank’s intransigence responsible for causing India’s growth drag. Further signs of alignment are reflected in the governor’s remarks on the economic cost of regulation and the trade-off between prudence and efficiency, echoing sentiments from the recently announced Budget.
Growth-inflation projection mix hints at tentativeness: RBI’s economic outlook projects a moderate GDP growth revival. This is in line with the projections made by the Economic Survey of 6.3-6.8 per cent for FY26.
Notwithstanding the guidance of a resilient economy, the projections reflect a sub-par outlook relative to the perceived potential growth of over 7 per cent. This is despite the expected moderation in inflation trajectory. The average inflation for 4QFY25-2QFY26 has been scaled down by 10 bps to 4.3 per cent and the full year FY26 at 4.2 per cent is lower than 4.8 per cent in FY25.
RBI’s mix of growth-inflation projections can be summarised as follows:
Lower inflation driven by moderation of food inflation overweighing rise in core inflation.
The exogenous drag on growth from rising global protectionism and tight fiscal strategy are assumed to be overweighed by gains in household situation, better employment and wages and income tax cuts along with the expectation of private capex revival and strong exports of services.
RBI’s hypothesis of growth revival lacks solidity:
It underplays the risks from downscaling in government spending and global trade protectionism; sectors that were the major drivers of the post-pandemic recovery.
Given the tapering of sales and profit growth of Indian corporates in the past three quarters, assumptions of better compensation growth and private capex revival are optimistic.
The implication of an income tax cut, translating into ₹1 trillion stimulus to the middle-income households in the formal sector can induce some urban consumption revival, but impacting just 0.5 per cent of overall household consumption, its multiplier effect will be small and some of it can leak out by way of higher imports.
The impact of tax sop to middle-income consumers can have an impetus on retail inflation compounding the pass-through impact of recent currency depreciation on imported inflation and WPI.
If the rate easing by the RBI induces a revival of retail lending, there can be an upside impetus to core inflation.
The assumption that food inflation will moderate more than the rise in core inflation is juxtaposed with the assumption of an improved supply of agri-produce, which is contingent on weather conditions and global agri price trends, both of which are subject to high volatility.
RBI underplays global risks
The RBI also tried to play down the risks from the strengthening US dollar, receding probability of US Fed easing with a view to dousing concerns on the sharp depreciation in rupee-dollar recently. While the RBI reiterates its stance that India follows a flexible exchange rate, the Governor emphasised that the RBI has a large forex buffer to cover imports and bountiful remittance inflows. Growth underperformance can translate into capital outflows and sustained rupee depreciation. This is specially so in the backdrop of the narrow 10-year India-US yield spread at 220 bps, which can intensify with the 25 bps rate cut announced today. Hence, the path towards our 90-92 levels for rupee-dollar can be hasten.
Transmission of rate easing less obvious: Monetary policy refrained from elaborating on the peak level of credit-deposit ratio at 80.8 per cent of banks, and the prospect of transmission of rate cut announced today. The likelihood of lending rates responding faster than deposit rates, in the context of sustained paucity of deposits implies that banks will see margins falling further.
The communication that regulatory tightening on retail lending and its desired results have played out, signals a possible easing of regulatory rigour and revival in credit demand even at the peak level of CD ratio and household debt/personal disposable income at 52 per cent. The imbalances in the banking sector, both with respect to limitations from peak CD ratio and asset quality can continue amid the change in regulatory and policy rate stance.
In sum, stepping on to a rate easing stance of the RBI reflects its acquiescence to the rising demand for monetary policy accommodation. However, several variables indicate that the counter-cyclical easing may have been induced amid prevailing macro imbalances, which can lead to its ineffectiveness. The discordance between the perceived potential growth of 7 per cent or more and effective lower levels, implies that India’s growth revival deserves structural policy redressal rather than counter-cyclical monetary easing.
The writer is Head of Research – Strategy & Economics, Systematix Institutional Equities
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