Until Wednesday, a 25 bps policy rate cut was round the corner. Headline inflation was reasonable, but growth slowed, forcing economists to logically predict a rate reduction during the RBI’s monetary policy review. Big misjudgment, as it happens. Citing upward risks to inflation and global headwind, the central bank unexpectedly turned hawkish.
Its shift from an accommodative to a neutral stance could move rates in either direction, though the probability of rounding off repo rate at 6 per cent in April from the current 6.25 per cent is decidedly weaker. Retail inflation at 3.41 per cent in December may be the lowest in nearly two years, but core inflation, i.e., excluding food and fuel, remains sticky. Uncertainty on American policies, rising crude oil prices, exchange rate volatility, and the fuller effects of the 7th Central Pay Commission payout could exert pressure on the 4 per cent inflation target, which RBI is firm on achieving.
In the past, the RBI downplayed the Pay Commission impact as a one-off effect, but bringing this variable back into its monetary policy equation is surprising. The RBI remains watchful of demonetisation’s impact on prices and output gap and accordingly lowered GVA estimates from 7.1to 6.9 per cent for FY17.
However, it expects consumer demand in cash-intensive sectors like retail trade, hotels and restaurants to warm up. If any of the above factors harden, it will tighten financial conditions, and mark the end of the current rate cut cycle, which began in January 2015. However, chances of lower rates will still be a reality as the average lending rates are down by 85–90 bps, as against a 175 bps cut in policy rates.
Further relief in lending rates depends on financial sector reforms, bank recapitalisation and eliminating NPAs. Despite efforts, gross NPAs remain high. If there was a contest for the title ‘sick and stressed’, public sector banks would walk it. What’s required is an out-of-the-box solution to prevent banks from falling.