RBI policy move keeps markets guessing

The central bank got room to effect 25 bps rate cut due to a change in its stance on neutral real rate and the timeframe for achieving the inflation target

The limited explanation on the Reserve Bank's lowering of the real interest rate and the time to be taken for achieving the four per cent Consumer Price Index (CPI) inflation target has markets guessing on the trigger and implications.

The central bank got room to effect a 25 basis point (bp) rate cut due to a change in its stance on the neutral real rate and the timeframe for achieving the inflation target.

Global financial group Citi said the real interest rate band of 1.5 to two per cent the previous RBI governor, Raghuram Rajan, had talked about had been lowered to 1.25 per cent. The real interest rate is the difference between CPI inflation and yield on one-year treasury bills.

With inflation at five per cent and the repo rate now at 6.25 per cent, there is no space to further cut the latter, unless inflation surprises further on the downside. But, the lowering of the real interest rate band is surprising. RBI did not elaborate on why, except to say it changes over time.

Religare, a domestic financial services unit, said RBI's repo cut was shrouded by cautious commentary over the inflation trajectory. RBI did not give a specific timeline to achieve the four per cent inflation target.

Taking a real rate of 1.25 per cent, an inflation rate of four per cent corresponds to a repo rate of 5.25 per cent in the medium term. This suggests a 100 bp interest rate cut is likely if inflation moderates to around four per cent, said Citi.

One analyst with a rating agency said in the absence of a detailed explanation on major changes, it was back to "reading tea leaves and making own interpretations".

Nomura, in a note, said the real rate (one-year T-bill rate minus expected inflation) target had been lowered from 1.5-2 per cent to 1.25 per cent, based on the argument that neutral real rates had moderated globally. True, although this argument was not made earlier.

Also, with global neutral real rates closer to zero, we are not sure about the sanctity of the new number (1.25 per cent), and think it could well be lowered even further, Nomura said.

Radhika Rao, economist at Singapore-based DBS Bank, said while inflation estimates were held unchanged, Tuesday's rate cut largely stemmed from a change in the real neutral rate framework.

RBI highlighted that India's real neutral rate had declined, in line with the global trend and due to lower potential output and demographics, DBS said.