Economist

Richard Iley

Macroeconomics

CPI inflation's continued swoon in May is likely to intensify the clamour for another rate cut by RBI. But the apex bank is likely to remain deaf to these calls for a variety of reasons. First, liquidity remains extraordinarily flush ensuring that downward pressure on effective lending rates continues. The monetary impulse therefore remains positive even as the policy rate has been held static. Second, low inflation today is a necessary, but not sufficient argument for further ease. Monetary policy must be forward looking with the central bank's inflation forecast the intermediate target of policy. CPI's plunge in April and May has pulled down the RBI's inflation forecast for FY2018H2 but so far not decisively. Moreover, forward looking measures of inflation expectations remain unanchored and seem to be responding only tentatively to ultra-low spot inflation. There is therefore a strong argument for RBI to lean against the wind and set policy mildly restrictive to bolster credibility as the new inflation target regime beds down. Lastly, a distinction must be drawn between the orthodox interest-rate channel of monetary policy and the credit channel which supports and augments it. RBI's reduction in the Statutory Liquidity Ratio (SLR) and easing of asset provisions and risk weights for home loans should swell the credit channel. Overall, then, the case for further 'formal, policy ease by RBI remains limited. Super-abundant liquidity, falling effective rates and targeted easing measures mean that the monetary impulse remains expansionary. Current low inflation readings can reasonably be expected to be ephemeral given lingering upside risks. Cutting rates further now only to have to quickly reverse later in the year would damage still nascent credibility.

CPI inflation's continued swoon in May is likely to intensify the clamour for another rate cut by RBI. But the apex bank is likely to remain deaf to these calls for a variety of reasons. First, liquidity remains extraordinarily flush ensuring that downward pressure on effective lending rates continues. The monetary impulse therefore remains positive even as the policy rate has been held static. Second, low inflation today is a necessary, but not sufficient argument for further ease. Monetary policy must be forward looking with the central bank's inflation forecast the intermediate target of policy. CPI's plunge in April and May has pulled down the RBI's inflation forecast for FY2018H2 but so far not decisively. Moreover, forward looking measures of inflation expectations remain unanchored and seem to be responding only tentatively to ultra-low spot inflation. There is therefore a strong argument for RBI to lean against the wind and set policy mildly restrictive to bolster credibility as the new inflation target regime beds down. Lastly, a distinction must be drawn between the orthodox interest-rate channel of monetary policy and the credit channel which supports and augments it. RBI's reduction in the Statutory Liquidity Ratio (SLR) and easing of asset provisions and risk weights for home loans should swell the credit channel. Overall, then, the case for further 'formal, policy ease by RBI remains limited. Super-abundant liquidity, falling effective rates and targeted easing measures mean that the monetary impulse remains expansionary. Current low inflation readings can reasonably be expected to be ephemeral given lingering upside risks. Cutting rates further now only to have to quickly reverse later in the year would damage still nascent credibility. 

RBI: Cutting Edge