As expected by the markets and economists, the Reserve Bank of India (RBI), in its first bi-monthly credit policy review on Tuesday for FY2016-17 has cut repo rate by 25 basis points (bps) to 6.50%. The central bank also decided to narrow the policy rate corridor from 100 bps to 50 bps by reducing the marginal standing facility (MSF) rate by 75 bps and increasing reverse repo rate by 25 bps.

 

With repo rate reduced to 6.50%, the reverse repo rate under the liquidity adjustment facility (LAF) will now be 6%. The Central bank also cut the minimum daily maintenance of cash reserve ratio (CRR) to 90% from 95%, while keeping CRR unchanged at 4%. The bank rate, which is aligned to the MSF rate also stands adjusted to 7%.

 

In a statement, RBI Governor Dr Raghuram Rajan said, "Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates. The reduction in small savings rates announced in March 2016, the substantial refinements in the liquidity management framework announced in this policy review and the introduction of the marginal cost of funds based lending rate (MCLR) should improve transmission and magnify the effects of the current policy rate cut. The stance of monetary policy will remain accommodative. The Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead, with a view to responding with further policy action as space opens up."

 

"Given that new instruments such as variable rate reverse repo auctions allow the Reserve Bank to suck out excess short term liquidity from the system without the excess liquidity being deposited with the Reserve Bank through overnight fixed rate reverse repo, it is possible for the Reserve Bank to keep the system closer to balance on average without the operational rate falling significantly. Thus, the past rationale for keeping the system in significant average liquidity deficit no longer is as compelling, especially when the policy stance is intended to be accommodative. Moreover, given that the Reserve Bank’s market operations rather than depositing or borrowing at standing facilities determine the operational interest rate, the policy rate corridor can be narrowed, as suggested by the Expert Committee," he added.

 

Chanda Kochhar, MD and CEO, ICICI Bank, said, "The higher than normal systemic liquidity deficit had been a matter of concern among market participants. The announcement that the RBI will progressively lower the average liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality significantly addresses this concern. This should support the transmission of RBI’s accommodative policy stance. The reduction in the repo rate signals that overall inflation trends are in line with expectations, and also responds to the Government’s commitment to fiscal prudence."

Commenting on the monetary policy, Arundhati Bhattacharya, Chairman, SBI, said, "The RBI decision to cut repo rates by 25 basis points was as per market expectations even as the liquidity management measures were a pleasant gift to the market. The decision to keep liquidity deficit at neutral mode and also narrowing the LAF corridor will result in a predictable and stable liquidity regime going forward facilitating better transmission across financial markets."

 

Nomura, in a note, said, "We believe the narrowing of the corridor supports our steepening view in both swap and bond curves. This will reduce the volatility in overnight rates and will ensure that the RBI can become aggressive with liquidity infusions. Also, MIBOR need not necessarily trade over the repo rate in medium term".

 

According to RBI, retail inflation measured by the consumer price index (CPI) dropped sharply in February after rising for six consecutive months. This favourable development was due to a larger than anticipated decline in vegetable prices, helped by prices of pulses starting to come off the surge that began in August, and effective supply management that helped limit cereal price increases. Accordingly, food inflation eased for the first time in the second half of 2015-16. "Notably, this occurred on a decline in prices rather than favourable base effects, which were at work in the first half of the year," it said.

Inflation in the fuel group moderated across electricity, kerosene, cooking gas and firewood, the latter easing pressures on rural inflation. Three months ahead household inflation expectations declined to a single digit for the second consecutive round of the survey in response to these dynamics.

CPI inflation excluding food and fuel edged up in February, mainly under housing, education, personal care and transport and communication, suggesting capacity constraints in the services sector. Excluding petrol and diesel from this category, inflation stayed elevated and persistent at or above 5%, indicating a possible resistance level for further downward movements in the headline, the central bank says.

RBI said, "The stubborn underlying inflation momentum is unlikely to be helped by the 7th Pay Commission award and the effects of the one-rank-one-pension (OROP) award, or by the cost-push effect of the increase in the service tax rate. However, rural wage growth as well as the rate of increase in corporate staff costs was moderate. Also, input and output prices polled in purchasing managers' surveys rose modestly for manufacturing and services."

"Going forward, CPI inflation is expected to decelerate modestly and remain around 5% during 2016-17 with small inter-quarter variations. There are uncertainties surrounding this inflation path emanating from recent unseasonal rains, the likely spatial and temporal distribution of monsoon, the low reservoir levels by historical averages, and the strength of the recent upturn in commodity prices, especially oil. On the other hand, there will be some offsetting downside pressures stemming from tepid demand in the global economy, Government's effective supply side measures keeping a check on food prices, and the Central Government's commendable commitment to fiscal consolidation," the central bank added.

 

Saravana Kumar, Chief Investment Officer, LIC Nomura Mutual Fund, says, "While the stance of monetary policy remains accommodative, the tone of the RBI’s policy was not dovish. It is possible that CPI inflation will undershoot RBI trajectory, and is expected further repo rate cut of 25bps in June ’16.  The room for any aggressive rate cut is significantly lower now as effects of 7CPC (estimated 100-150 bps higher inflation) and slower disinflationary impulses from the global economy amongst others will keep the inflation trajectory on a steady but slower downtrend".

RBI feels that the uneven recovery in growth in 2015-16 is likely to strengthen gradually into 2016-17, assuming a normal monsoon, the likely boost to consumption demand from the implementation of the 7th Pay Commission recommendations and OROP, and continuing monetary policy accommodation. It said, "After two consecutive years of deficient monsoon, a normal monsoon would work as a favourable supply shock, strengthening rural demand and augmenting the supply of farm products that also influence inflation. On the other hand, the fading impact of lower input costs on value addition in manufacturing, persisting corporate sector stress and risk aversion in the banking system, and the weaker global growth and trade outlook could impart a downside to growth outcomes going forward."

According to the Reserve Bank, liquidity conditions, which had tightened since mid-December, were stretched further by the larger-than-usual accumulation of cash balances by the Government, unusually heightened and persistent demand for currency, a pick-up in bank credit and flatter deposit mobilisation at this time relative to past years.

 

Dr Arun Singh, Lead Economist of Dun & Bradstreet India, said, “The lowering of policy rate, and more importantly, measures to support liquidity needs in the system are laudable as it would improve the transmission process. Lower interest rates are likely to have a bigger impact on consumer spending. There is a need for further rate cut in 2016 to lower cost of funds for the industry and spur investments, which has been rather flat. Policy rate cut along with government recent reforms initiatives are likely to provide push to the recovery of Indian economy going forward.”

 

Here are the latest policy rates following RBI review…

 

Repo Rate.......................6.50%

Reverse Repo Rate.........6%

CRR................................4%

Bank Rate.......................7%