RBI likely to go in for more interest rate cuts, says Nomura

Due to continued weakness in domestic demand and moderate core inflation Nomura expects a 25 basis points cut at the next RBI policy meeting on 18 June 2012
 

Brokerage and research firm Nomura has said that there will be an additional 50 basis points cut in repo rate in 2012 (25 basis points cut previously) due to continued weakness in domestic demand and moderate core inflation, with a 25 basis points cut at the next RBI policy meeting on 18 June 2012. The cash reserve ratio (CRR) is not expected to be cut on 18 June, as liquidity is closer to the RBI’s comfort zone and open market operations can be used to address the liquidity mismatch, predicts Nomura.

The interest rate cuts are only a quick fix to growth. Without concomitant fiscal tightening, loose monetary policy will likely fan inflation and lead to greater macroeconomic instability down the road.

The research firm is changing its policy rate call. It expects 50 basis points of additional repo rate cuts in 2012 (terminal repo rate of 7.50%), compared with its earlier forecast of 25 basis points, due to a continued weakness in domestic demand and rising downside risks to the global growth outlook. The reasons for the expected  25 basis points repo rate cut on 18 June 2012 include: (a) weaker-than-expected real GDP growth of 5.3% y-o-y in Q1 2012, belying Nomura’s and the RBI’s view that growth had bottomed in Q4 2012; (b) despite rising headline WPI inflation, core WPI (non-food manufactured) inflation has continued to moderate, which suggests that pricing power has declined (A further moderation in core inflation in May, data due on 14 June 2012, is expected); and (c) Brent oil prices have fallen to around US $100/barrel, more than offsetting the drag from the rupee depreciation.

Nomura has assigned a 20% probability to a 50 basis point rate cut at the RBI’s June 2012 meeting. While sluggish growth, low core inflation and weak policy rate transmission argue for a more aggressive 50 basis points rate cut, The brokerage expects a 25 basis point rate cut due to elevated headline inflation (primarily due to persistently high food inflation).

The CRR at 4.75% is close to the all-time low of 4.50% and needs to be kept ready as an emergency buffer to inject liquidity if conditions worsen, says Nomura. Upside risks in headline inflation are expected in the coming months. However, continued moderation in core inflation will likely prompt the RBI to accord a higher priority to growth. As such, following the expected 25 basis points repo rate cut at the June 2012 meeting, Nomura anticipates another 25 basis points cut in the second half of the year.

The current slowdown in growth is largely a payback from continued fiscal excesses and reflects slow government decision-making over the past year. Real effective exchange rate depreciation has already started to ease monetary conditions. As such, the current Indian stagflationary environment needs tight fiscal policy to create a more stable macro backdrop.

Nomura reasons that there are two issues with cutting interest rates: First, in the current tight liquidity environment, the transmission of policy rate cuts may be delayed and sub-optimal. Second, and more importantly, when inflationary expectations are in double-digits and potential growth is at risk of falling below 7%, it will not take much for inflationary pressure to rear its head. Without concomitant fiscal tightening, loose monetary policy will likely fan inflation and lead to greater macroeconomic instability down the road.

Thus, Nomura predicts a gloomy picture ahead for the banks and bond market—not to speak of instability in the equities and forex market—in India, in the absence of firm measures from the government.

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