Here’s why RBI kept rate cut at 25 bps when it could do 50 bps

NEW DELHI: If you are still nursing your grievance against the Reserve Bank of India (RBI) for not making it 50 basis points when it had all good reasons to do so, just know that there was a method in the madness, if you want to put it that way.

In hindsight, RBI actually delivered you more than 50 basis points, not in number but in effect. That’s what most analysts and economists would tell you. And how!

But first, let’s examine why RBI stopped at 25 bps when it could have gone all the way to 50 bps?

During its last money policy review in February, RBI had said it was looking for clarity on the plans for fiscal consolidation, progress on structural reforms and the inflation trend for easing policy rates further. Since then, almost all the conditions for monetary easing have been met.

All this while, controlling inflation has been the top priority of RBI. The CPI inflation, which also captures the trend in the more volatile food prices, had showed some spike since August last year, but in February the all-India general CPI inflation dipped to a four-month low of 5.18 per cent, snapping the rising spiral in the six months prior to that.

The next big worry was a fresh Fed rate hike, which was addressed by Fed Chair Janet Yellen herself, who last Thursday painted a rather cautious picture for the US economy, signalling that the next round of Fed rate hike is sometime away.

RBI’s third concern was any profligacy on the part of the government. With a big pay bonanza on its way for government employees and retired army men, the economy is anyway preparing for a spurt in spending, which could push up inflation. Finance Minister Arun Jaitley took care of that in the Budget.

But even when the worries evaporated on their own, RBI went for just a 25 basis points repo rate cut. Because there was hardly any room for the central bank to do anything more within its policy framework.

For some time now, RBI has maintained that the inflation-adjusted interest rate of about 1.0-1.5 per cent is appropriate for the current phase of the Indian economy. If it has to stick to that line and given the inflation expectation at 5 per cent, the real interest rate should be in the range of 6.0-6.50 per cent. And after the 25 basis points cut, that is where the repo rate stands, 6.5.

Says Ritesh Jain, CIO of Tata Mutual Fund: “With the latest cut, RBI is nearing the end of its policy-easing cycle. A rate cut beyond 25 bps would have lowered the real rate below RBI’s comfort range, given the upside risks to inflation as pointed out by it.”

Remember, the upside risks to inflation are real and big.

On Tuesday, RBI said it expects inflation to decelerate modestly and remain around 5 per cent during the year. It cited the recent unseasonal rains, an erratic distribution of monsoon, the recent upturn in commodity prices, especially oil, and the imminent spending boost from the seventh Pay Commission award and OROP as key risk factors.

That said, the effective rate reduction from Tuesday’s policy has been much more than 25 basis points. Most economists who did the math said the liquidity measures were tantamount to more than a 25 bps repo rate cut, as they will also help better transmission of the 125 basis points rate cuts that RBI had delivered in the last financial year in the new environment of marginal cost-based lending rate (MCLR) and market-linked small savings rates implemented from April 1.

“With the call rate likely to fix closer to the repo rate (compared with +15 bp earlier), the effective reduction in the weighted average call rate should be larger over time,” said Sonal Varma, Economist, Nomura India.

Fast-tracking policy transmission and ensuring adequate liquidity provision were the key focus of RBI’s latest policy stance.

Says Jain of Tata Mutual Fund, RBI’s measures to bring the systemic liquidity to neutral along with the narrowing of the corridor to 50 bps and CRR maintenance at 90 per cent will allow overnight rates to remain very close to the repo rate or even cause them to drift marginally lower. This will ensure that the easy policy stance percolates to the real economy and lowers financing costs.