The RBI, in its third quarter review of monetary policy, delivered more than expected. Embarking on the path of monetary easing after a hiatus of nine months, and in line with our expectations and earlier guidance, the RBI reduced the repo rate by 25 bps to 7.75%.
In addition, the RBI pleasantly surprised the market with a cut in the CRR by 25 bps to 4.0%.
Since the second quarter review of monetary policy in October 2012, there has been some softening in the growth-inflation balance. This is evident from RBI?s revised outlook on both growth (FY13 GDP estimate was lowered to 5.5% from 5.8% earlier) and inflation (WPI inflation estimate for Mar-13 was lowered to 6.8% from 7.5% earlier).
The sharp downward revision in inflation estimate despite the bold upward adjustment to domestic fuel prices over the last four months is noteworthy. This, in our view, is reflective of the impact of past monetary tightening, stable commodity prices and limited pricing power, amid a negative output gap, leading to significant reduction in demand side pressures.
With core inflation remaining below its long term (seven-year) average of 4.7% for two straight months, amid a soft growth momentum, and government persisting with measures to correct twin deficits, today?s move stands completely justified.
Going forward, the growth-inflation trajectory is expected to turn favorable, albeit gradually.
We expect GDP growth to improve to 6.5% in FY14 from 5.7% in FY13 with average WPI inflation expected to ease by around 70-80 bps to 6.7-6.8% in FY14. With continued support from fiscal policy (through implementation of reform measures announced earlier and a downward adjustment in twin deficits) and stable global conditions, monetary policy would continue to address growth risks.
However, the extent of easing could be limited around 50-75 bps in CY13 as despite the expected adjustment, elevated levels of twin deficits could potentially constrain the extent of monetary accommodation. Moreover, supply-side inflationary pressures would take time to alleviate and implementation of unpopular reforms could turn fiscal consolidation a challenging task in the run-up to the upcoming elections.
On balance, it appears that the RBI is guarded in terms of its guidance, but stands prepared to provide incremental monetary accommodation, if demand side inflationary pressures remain benign, commodity prices remain stable and, last but not least, fiscal actions do not deviate from fostering a complementary policy environment.
However, the unintended consequence of fiscal consolidation has resulted in tight liquidity conditions. A reduction in the usual pace of government spending over the last three months has led to a buildup of cash surplus with the RBI leaving the banking system devoid of adequate liquidity.
If the government unwinds this cash surplus, liquidity deficit in the system could be easily reduced by more than half.
Auction heavy February and an expected spurt in government revenue through disinvestments in the coming weeks is likely to increase the cash surplus further. The persistence of high cash surplus with the RBI highlights the frictional stress on liquidity, something that the CRR cut is expected to address.
The writer is senior president & chief economist, Yes Bank
