The Reserve Bank of India (RBI) has now cut its rate by 125 basis points this year with today's cut expected by financial markets. In August, when the RBI maintained its rate, it had held out the prospect of an easing of policy today pending a decline of inflationary pressures, the outturn of the full monsoon, any policy shift by the U.S. Federal Reserve and transmission of past rate cuts.
"Since our last review, the bulk of our conditions for further accommodation have been met," RBI Governor Raghuram Rajan said in a statement, adding that inflation has dropped to a nine-month low, as expected.
India's consumer price inflation rate eased to 3.66 percent in August, the lowest level since November 2014, and Rajan said the RBI's target of 6.0 percent inflation by January 2016 was likely to be achieved.
"Therefore, the focus should now shift to bringing inflation to around 5 percent by the end of fiscal 2016-17," said Rajan, saying inflation was expected to reach 5.8 percent in January next year a shade below projections. India's fiscal year begins April 1.
India's inflation rate is likely to move higher from September for a few months due to base effects and Rajan said the pass-through of the recent depreciation of the rupee would have to be carefully monitored although lower oil prices should have an offsetting effect.
While the RBI will maintain an accommodative policy stance, Rajan said the its focus is the near term will shift to working with the government to ensure that any impediments to banks passing on the bulk of the 125 basis point cut in policy rates are removed.
So far commercial banks have transmitted the RBI's past rate cuts via commercial paper and corporate bonds by only a limited extent and the median base lending rates have fallen by only 30 basis points despite "extremely easy liquidity conditions," Rajan said.
Bank deposit rates, however, have been reduced significantly, suggesting further transmission is possible, he added.
Looking abroad, Rajan said global economic activity had weakened, suggesting that commodity prices will remain contained and low industrial capacity indicates that more domestic demand is needed to substitute for weakening global demand so the domestic investment cycle picks up.
The Reserve Bank of India issued the following fourth bi-monthly monetary policy statement by Governor Raghuram G. Rajan. Copied below is Part A: Monetary Policy.
"Monetary and Liquidity Measures
On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:
- reduce the policy repo rate under the liquidity adjustment facility (LAF) by 50 basis points from 7.25 per cent to 6.75 per cent with immediate effect;
- keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liability (NDTL);
- continue to provide liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 14-day term repos as well as longer term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and
- continue with daily variable rate repos and reverse repos to smooth liquidity.
Consequently, the reverse repo rate under the LAF stands adjusted to 5.75 per cent, and the marginal standing facility (MSF) rate and the Bank Rate to 7.75 per cent.
Assessment
2. Since the third bi-monthly statement of August 2015, global growth has moderated, especially in emerging market economies (EMEs), global trade has deteriorated further and downside risks to growth have increased. In the United States, industrial production slowed as capital spending in the energy sector was cut back and exports contracted, weighed down by the strength of the US dollar. Consumer spending stayed buoyant, however, amidst steadily improving labour market conditions. In the Euro area, a fragile recovery strengthened, supported by domestic consumption, less slack in the labour market and improving financial conditions engendered by ultra-accommodative monetary policy. Economic activity in Japan, however, is faltering under the weight of weak private consumption and exports, with both business and consumer confidence subdued. EMEs are caught in a vortex of slowing global trade volumes, depressed commodity prices, weakening currencies and capital outflows, which is accentuating country-specific domestic constraints. China’s intended rebalancing from investment towards consumption is being hit by the stock market meltdown, slower industrial production and weaker exports. The devaluation of the renminbi on August 11, while mild, has unsettled financial markets across the world. Brazil and Russia are grappling with recession and runaway inflation, while South Africa is facing tightening structural constraints which threaten to tip it into a downturn.
3. Since the Chinese devaluation, equity prices, commodities and currencies have fallen sharply. Capital flight from EMEs into mature bond markets has pushed down developed market yields, and risk spreads across asset classes have widened. Although volatility ebbed in early September and capital flows returned cautiously to some EMEs, sentiment in financial markets remains fragile. The September 17 decision of the Federal Open Market Committee to stay on hold in response to global conditions and weak domestic inflation lifted financial markets briefly, but overall financial conditions are yet to stabilise.
4. In India, a tentative economic recovery is underway, but is still far from robust. In agriculture, sown area has expanded modestly from a year ago, reflecting the timely and robust onset of the monsoon in June, but the southwest monsoon is currently deficient by 14 per cent – with production-weighted rainfall deficiency at 20 per cent. Nevertheless, the first advance estimates indicate that food grain production is expected to be higher than last year, reflecting actions taken to contain the adverse effects of rain deficiency through timely advisories and regular monitoring of seed and fertiliser availability. Allied farm activities, which are more insulated from the monsoon, remain resilient and could partly offset the effects of adverse weather on crop production. Rural demand, however, remains subdued as reflected in still shrinking tractor and two-wheeler sales.
5. Manufacturing has exhibited uneven growth in April-July, with industrial activity slowing sequentially in July, although it has been in expansionary mode for the ninth month in succession. Industries such as apparel, furniture and motor vehicles have experienced acceleration. Furthermore, the resumption of growth in production of consumer durables in recent months, after a protracted period of contraction over the last two years, is indicative of some pick-up in consumption demand, primarily in urban areas. Since our last review, however, external demand conditions have turned weaker, suggesting a more persistent drag from lower exports and cheaper imports due to global overcapacity. This contributes to continuing domestic capacity under-utilisation, decelerating new orders and a rising ratio of finished goods inventories to sales.
6. As a result of still tepid aggregate demand, output price growth is weak, but input material costs have fallen further, leading to an increase in margins for most producers. Weak aggregate demand appears to have more than offset the effect of higher margins to hold back new investment intentions. The expansion in capital goods production, therefore, likely relates more to the revival of stalled projects than to a build-up of the green field pipeline. Survey-based business sentiment has been falling in recent quarters. The manufacturing purchasing managers’ index (PMI) nevertheless remained in expansion territory in August, although it slowed from July due to weak domestic and export order books.
7. In the services sector, construction activity is weakening as reflected in low demand for cement and the large inventory of unsold residential houses in some localities. Rising public expenditure on roads, ports and eventually railways could, however, provide some boost to construction going forward. Lead indicators relating to freight and passenger traffic are mixed. In August, the services PMI remained in expansion for the second consecutive month on improving new business, but business expectations remain subdued.
8. Headline consumer price index (CPI) inflation reached its lowest level in August since November 2014. The ebbing of inflation in the year so far is due to a combination of low month-on-month increases in prices and favourable base effects. Overall year-on-year food inflation dropped sharply, led by vegetables and sugar. Cereal inflation moderated steadily during April-August, but price pressures in respect of pulses and onions remained elevated.
9. CPI inflation excluding food and fuel eased in August for the second consecutive month, primarily due to the decline in petrol and diesel prices pulling down inflation in transportation. Fares other than for air transport have, however, remained inflexible downwards. Inflation in house rentals increased, but was more than offset by some moderation in the heterogeneous category of services, including education, personal care and effects, and health. Inflation expectations of households remained elevated in double digits likely in response to recent month-on-month increases in the prices of vegetables and pulses. Professional forecasters’ inflation expectations eased as credibility built around the January 2016 inflation target. Rural wage growth remains subdued and corporate staff costs decelerated.
10. Liquidity conditions eased considerably during August to mid-September. In addition to structural factors such as deposit mobilisation in excess of credit flow, lower currency demand and pick-up in spending by the government contributed to the surplus liquidity. In response, the Reserve Bank conducted variable rate reverse repos of overnight and longer tenors ranging from 2 to 20 days. As a result, the average net daily liquidity absorption by the Reserve Bank increased from ₹120 billion in July to ₹261 billion in August and further to ₹544 billion in September (up to September 15). Money market rates generally remained below the repo rate. As quarterly tax collections went out of the system from mid-September, deficit conditions returned and the Reserve Bank engaged in average net injections of the order of ₹544 billion (September 16 to 27), keeping the call money rate close to the repo rate. Some forms of bank credit such as personal loans grew strongly as did non-bank financing flows through commercial paper, public equity issues and housing finance.
11. With the weakening of growth prospects in EMEs and world trade volume growth falling below world GDP growth, India’s merchandise exports continued to decline in the first two months of Q2. Imports values also declined, but the sharp fall in international crude oil and gold prices was offset by rising import volumes. Non-oil non-gold imports went back into contraction after recording a marginal pick-up in the previous quarter, although there were higher imports of fertilisers, electronics and pulses. With services exports moderating, the widening of the merchandise trade deficit could lead to a modest increase in the current account deficit (CAD) during Q2. Net capital inflows were buoyed by sustained foreign direct investment and accretion to non-resident deposits, and reduced by portfolio outflows, mainly from equity markets. Foreign exchange reserves rose by US $ 10.4 billion during the first half of 2015-16.
Policy Stance and Rationale
12. In the bi-monthly policy statement of August, the Reserve Bank indicated that further monetary policy accommodation will be conditioned by the abating of recent inflationary pressures, the full monsoon outturn, possible Federal Reserve actions and greater transmission of its front-loaded past actions. Since then, inflation has dropped to a nine-month low, as projected. Despite the monsoon deficiency and its uneven spatial and temporal distribution, food inflation pressures have been contained by resolute actions by the government to manage supply. The disinflation has been broad-based and inflation excluding food and fuel has also come off its recent peak in June. The Federal Reserve has postponed policy normalisation. Markets have transmitted the Reserve Bank’s past policy actions via commercial paper and corporate bonds, but banks have done so only to a limited extent. The median base lending rates of banks have fallen by only about 30 basis points despite extremely easy liquidity conditions. This is a fraction of the 75 basis points of the policy rate reduction during January-June, even after a passage of eight months since the first rate action by the Reserve Bank. Bank deposit rates have, however, been reduced significantly, suggesting that further transmission is possible.
13. Looking forward, inflation is likely to go up from September for a few months as favourable base effects reverse. The outlook for food inflation could improve if the increase in sown area translates into higher production. Moderate increases in minimum support prices should keep cereal inflation muted, while subdued international food price inflation should continue to put downward pressure on the prices of sugar and edible oil, and food inflation more generally. It is important that pro-active supply-side management by the government be in place to head off any food price pressures should they materialise, especially in respect of onion and pulses. The pass-through of the recent depreciation of the rupee will have to be carefully monitored, although benign crude prices should have an offsetting effect. Taking all this into consideration, inflation is expected to reach 5.8 per cent in January 2016, a shade lower than the August projection (Chart 1).
14. The modest pick-up in the growth momentum in the first half of 2015-16 benefited from soft commodity prices, disinflation, comfortable liquidity conditions, some de-clogging of stalled projects, and higher capital expenditure by the central government. Underlying economic activity, however, remains weak on account of the sustained decline in exports, rainfall deficiency and weaker than expected momentum in industrial production and investment activity. With global growth and trade slower than initial expectations, a continuing lack of appetite for new investment in the private sector, the constraint imposed by stressed assets on bank lending and waning business confidence, output growth projected for 2015-16 is marked down slightly to 7.4 per cent from 7.6 per cent earlier (Chart 2). Concurrent indicators also suggest that the new GDP series shows higher growth than would the old series, which necessitates recalibrating old measures of potential output and the output gap to the new series.
15. Since our last review, the bulk of our conditions for further accommodation have been met. The January 2016 target of 6 per cent inflation is likely to be achieved. In the monetary policy statement of April 2015, the Reserve Bank said that it would strive to reach the mid-point of the inflation band by the end of fiscal 2017-18. Therefore, the focus should now shift to bringing inflation to around 5 per cent by the end of fiscal 2016-17. In this context, the weakening of global activity since our last review suggests that commodity prices will remain contained for a while. Still-low industrial capacity utilisation indicates more domestic demand is needed to substitute for weakening global demand in order that the domestic investment cycle picks up. The coming Pay Commission Report could add substantial fiscal stimulus to domestic demand, but the government has reaffirmed its desire to respect its fiscal targets and improve the quality of its spending. Under these circumstances, monetary policy has to be accommodative to the extent possible, given its inflation goals, while recognizing that continuing policy implementation, structural reforms and corporate actions leading to higher productivity will be the primary impetus for sustainable growth. Furthermore, investment is likely to respond more strongly if there is more certainty about the extent of monetary stimulus in the pipeline, even if transmission is slow. Therefore, the Reserve Bank has front-loaded policy action by a reduction in the policy rate by 50 basis points. Given our year-ahead projections of inflation, this ensures one year expected Treasury bill real interest rates of about 1.5-2.0 per cent, which are appropriate for this stage of the recovery.
16. While the Reserve Bank’s stance will continue to be accommodative, the focus of monetary action for the near term will shift to working with the Government to ensure that impediments to banks passing on the bulk of the cumulative 125 basis points cut in the policy rate are removed. The Reserve Bank will continue to be vigilant for signs that monetary policy adjustments are needed to keep the economy on the target disinflationary path.
17. The fifth bi-monthly monetary policy statement will be announced on December 1, 2015."
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