RBI May Cut Rates This Week But Urjit Patel Could Choose to Wait

At 3.2%, the headline fiscal deficit falls in the Goldilocks bucket, but it’s not what Urjit Patel asked for.

The monetary policy review that follows the Union Budget often ends up being a verdict of sorts on the government’s fiscal leanings. Since the fiscal deficit (and whether it ends up being expansionary for demand) is a key input into monetary policy, the Reserve Bank of India (RBI) tends to factor in the budget calculations for the year before deciding the course of interest rates.

This year will be no different. In fact, if anything, with a formal inflation target in place, the RBI will have to weigh the fiscal position ever more carefully.

Will The RBI’s Verdict Be Favorable?

At 3.2 percent, the headline fiscal deficit falls in the Goldilocks bucket. It’s not 3 percent, which is what Urjit Patel, who chaired the committee that revised the monetary policy framework, had asked for. But it’s lower than the 3.5 percent in fiscal 2016-17. There is also a commitment that the deficit would be brought down to 3 percent next year.

Within that headline number, most economists have noted the restraint exercised on the expenditure side. Overall expenditure is set to rise 6.6 percent this fiscal 2018 compared to 12.5 percent in fiscal 2017. The expenditure mix is also encouraging. For the first time in many years, current expenditure is set to decline 0.6 percent compared to the revised estimates of fiscal 2017. Current expenditure includes subsidies, interest expenses and other expenditure.

There is also no significant consumption stimulus in the budget. The tax cut for those earning Rs 2.5 lakh to Rs 5 lakh can be considered as one but the amounts are not significant. The government foregoes Rs 15,500 crore on account of these tax concessions. While this money may be incrementally used for consumption, the amount is small at a macro level. The other stimulus in the budget was in the form of a push to affordable housing, the multiplier effects of which will take time to play out.

Possible To Sneak In One Last Rate Cut...

Given a budget that stayed away from fiscal profligacy, and a headline inflation number which is well below the 5 percent target for March 2017, most economists believe that there is room for one last 25 basis point rate cut. While some expect the rate cut to come this week; others feel that an April rate cut is more likely.

With CPI inflation likely to undershoot the 5 percent target by more than 50 basis points, we expect the RBI to reciprocate with government delivering on fiscal consolidation. We continue to expect 25 bps rate cut in the February policy review.

Shubhada Rao, Chief Economist, Yes Bank

The better than feared deficit target and commitment to fiscal consolidation will keep hopes of a RBI rate cut alive... While the timing of RBI cuts remains uncertain, investors are now unlikely to question the possibility of one 25 basis point rate cut that is currently priced into the OIS (overnight indexed swap) curve.

Samiran Chakraborty, Chief Economist - India, Citibank

With oil on the climb, pressures from higher government wages, and Fed rates expected to rise, the space for rate cuts is quickly dwindling. We expect one final 25 basis point rate cut in the cycle.

Pranjul Bhandari, Chief Economist, HSBC India

They Can, But Should They?

With the question of ‘can they’ answered, it may be worth asking ‘should they?’ The answer to that lies in demonetisation.

What a 175 basis points in repo rate cuts couldn’t do was accomplished by a surge in deposits following demonetisation.

Banks have cut rates steeply in January led by State Bank of India which slashed its base rate by 90 basis points. ICICI Bank Ltd, HDFC Bank Ltd and others have all cut rates by 70-90 basis points, essentially completing the process of monetary policy transmission.

The result is that a significant monetary stimulus is currently underway which, if sustained, should help boost the economy once the immediate pressure on cash transactions goes away.

The behavior of banks has also once again made it clear that they respond to liquidity triggers far more quickly than policy rate triggers. As such, the RBI may not want to expend all its rate ammunition since banks are unlikely to pass it on in any case.

Yes, the risk of a reversal in rates remains if a large chunk of the deposits flow out, but most bankers are expecting anywhere between 25-40 percent of deposits to stay in the system. If this holds true, the low rates should stick.

The Return Of The Hawk

The minutes of the December monetary policy review reaffirmed the hawkish credentials of RBI governor Urjit Patel. Having surprised the markets by holding rates steady, Patel’s statement dismissed growth risks from demonetisation as being transitory and focused on the risks to inflation.

“Inflation excluding food and fuel remains sticky. International crude oil prices have firmed up,” wrote Patel.

Even as growing credibility in the disinflation process in India has lowered households’ inflation expectations from double digits prevailing until December 2015, they remain elevated and feed into the services component of inflation.

Urjit Patel

In conclusion, Patel said that securing inflation at 4 percent remains the primary objective.

In short, Patel left no ambiguity about his priorities.

With core consumer price inflation remaining at close to 4.8 percent even though headline inflation fell to 3.4 percent in December, a hawkish Patel may choose to stay away from a rate cut. Equally, uncertainty on global commodity prices and currency movements could stop him from voting in favor of a rate cut.

And if he does, that would be just fine.