Too hawkish a prediction?

As was widely expected, the Reserve Bank of India (RBI) reduced its overnight repo rate by 25 basis points, taking it to 7.25 per cent. What was perhaps not so widely expected was its rather dire characterisation of inflation risks. The equity markets clearly read in Governor Raghuram Rajan's statement a signal that this might be the last reduction for a while, leading to a massive sell-off. This is the first time in the most recent series of rate cuts that investors have reacted so negatively. They clearly believe that the prospects of an economic recovery and the earnings growth that it brings have been dampened by the RBI's cautious stance. On its part, the RBI has evidently re-assessed inflation risks, particularly in light of a relatively pessimistic monsoon forecast, which now sees a nation-wide shortage of about 12 per cent in rainfall during the upcoming season. Its concerns about resurgent food inflation as a consequence of this are reinforced by the recent increases in crude oil prices. Overall, its projection of year-end consumer inflation is now six per cent - which, given that its target is over that horizon, would leave it no space to effect any further cuts. Not doing anything that may weaken the credibility of the RBI's commitment to the target is, understandably and correctly, a priority for Governor Rajan.

The question that will be asked is: even if the concerns are entirely valid, wasn't there some merit in toning down the hawkishness? Yes, the policy statement made the usual noises about subsequent rate actions being data driven; the reference to front-loading rate cuts and then waiting and watching for actions and developments on food supplies, infrastructure projects and so on all served to reinforce the message that there wouldn't be further cuts. As far as monsoon forecasts are concerned, it is well-known that the national forecast, even if it proves to be accurate, is not a particularly good predictor of agricultural output and food prices. Variations across regions and, particularly, the monthly distribution of rainfall are far more important. Thus the statement could have been more guarded about the monsoon risk and its implications for future policy actions.

One issue on which Governor Rajan has expressed irritation is the resistance of banks to transmitting policy rate cuts. In yesterday's statement, he expressed some satisfaction about seeing the previous cuts now being passed on. However, there are questions about whether this process is sustainable. On the lending side, banks have become extremely risk-averse and unwilling to lend, as the credit growth numbers suggest. In trying to protect their balance sheets from further erosion due to non-performing assets, they have limited incentive to use lower rates to attract more business. On the deposit side, liquidity conditions have taken the yield curve back to a positive slope, making other fixed income products more attractive to investors. Lowering interest rates would further drive funds away from banks. In this context, the RBI's unwillingness to ease constraints on liquidity through reductions in the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) also points to a certain hawkishness and constrained transmission. For now, the RBI seems to have decided to stop playing the game and sit on the bench.