How will RBI's repo rate cut impact economy ahead of elections?

With elections round the corner, the Reserve Bank of India’s (RBI) decision on Thursday to slash the repo rate by 25 basis points to 6 per cent did not come as a surprise. It was widely predicted by economists that the Monetary Policy Committee (MPC) of the RBI would go for the 25 basis points cut. The repo rate or policy rate is the rate at which the RBI lends to commercial banks.

This is the second consecutive rate cut by 25 bps that the country is witnessing under its new RBI Governor Shaktikanta Das. Thursday's was the first of the six meetings that the MPC will conduct during the financial year 2019-20. The next meeting will be held in June.

Alongside slashing the repo rate, the RBI also made some predictions regarding the GDP growth rate and inflation. The GDP growth forecast for FY20 was lowered to 7.2 per cent from the earlier estimate of 7.4 per cent, citing a possibility that the El Nino could reduce Indian monsoons.

However, the El Nino is not the only winds that led to this drop in GDP growth forecasts. It comes amid looming global headwinds that contribute towards an uncertain economic scenario at the global front, in the backdrop of events like the trade war and ambiguity regarding crude oil prices. In light of this, the rate cut comes as a welcome move to increase consumer spending and boost liquidity in the economy. The RBI further stated that “the need is to strengthen domestic growth impulses by spurring private investment, which has remained sluggish”.

Moreover, the rate cut, coupled with the recent revision of the GST bracket, will help to improve sales in the real estate sector, as it reduces the burden on borrowers.

Thus, one would expect to encounter an ecstatic market in the aftermath of such a positive outlook propagated by the RBI’s neutral policy stance. However, the benchmark indices Nifty and Sensex closed 0.4 per cent and 0.49 per cent lower post the repo rate cut. Market experts attribute this to the fact that in spite of having room to do so, the RBI did not slash the repo rates further and take an accommodative stance.

The inflation forecast is predicted to be 2.9-3 per cent for the first half of the financial year, while it is slated to be between 3.5-3.8 per cent during the second half. These predicted rates remain well within the RBI’s target of 4 per cent for retail inflation, based on the consumer price index. The lower inflation forecast comes in the wake of an assumption of lowered food and fuel prices.

However, one gets a slightly altered perspective on looking at core inflation. Core inflation is a measure of inflation that does not take into consideration the extremely volatile food and energy sectors. The core inflation was 5.7 per cent in December 2018. This shows that the economy could be headed towards a period with rising core inflation, but reduced GDP growth. Such statistics hike inflationary expectations, which have been found to result in a self-fulfilling prophecy by propelling actual inflation rates. This could be a possible explanation as to why the RBI refrained from adopting an accommodative stance.

One common concern that has sprung up in the minds of the people is regarding the efficiency of the transmission mechanism, i.e., how effectively the benefits of the policy rate cut will be passed onto the general public. Even though the RBI reduced the repo rate by 25 bps in February, a reduction of lending rate by only 5-10 bps trickled down into the economy. There is a lot of skepticism regarding transmission even this time around, as was voiced by Pratip Chaudhuri, former Chairman of the State Bank of India during a televised debate. He clarifies that a 25bps cut in repo rate does not necessarily mean an equal lowering of the lending rate. “It doesn’t work that way because repo rate is an insignificant, miniscule portion of the banks’ borrowing cost. Main cost is the deposit cost, and banks today are in just no position to lower the deposit rate.”

Meanwhile, the RBI has left the Cash Reserve Ratio (CRR) unchanged at 4 per cent. This refers to the amount that commercial banks need to maintain as reserves with the central bank. This move also gives room to speculate on whether lowering the CRR along with the repo rate could have promoted better liquidity in the economy. The reverse repo rate has also been cut by 25 bps to 5.75 per cent. Further, the fiscal deficit target has been increased to 3.4 per cent, up from 3.3 per cent.

More clarity on the impact of this predicted rise would emerge only once the new government will present the full budget in July. Ultimately, like most instances, only time can give a finite stamp to the repercussions of the policy decision.