RBI cuts Repo Rate 25 bps

The Reserve Bank of India (RBI) governor Raghuram Rajan on Tuesday cut interest rates by 25 basis points (bps) for the third time this year, citing mixed indicators of recovery against the backdrop of easing inflation. The central bank, however, cited upside risks to inflation due to an expected weakness in monsoon rains, higher crude prices and volatilty in the external environment, suggesting further rate cuts are not a given. One basis point is one-hundredth of a percentage point. The benchmark repo (repurchase) rate now stands reduced to 7.25% from 7.5% earlier, effective immediately.

The policy is a Goldilock one, in line with the economy, said RBI governor Raghuram Rajan at a post-policy press conference, adding the central bank has used the room that was available for rate cuts. While reducing interest rates, RBI kept cash reserve ratio (CRR) steady at 4% and the statutory liquidity ratio (SLR), or the proportion of government bonds that banks need to hold, constant at 21.5%.

Banks have started passing through some of the past rate cuts into their lending rates, headline inflation has evolved along the projected path, the impact of unseasonal rains has been moderate so far, administered price increases remain muted, and the timing of normalization of US monetary policy seems to have been pushed back. With low domestic capacity utilization, still mixed indicators of recovery, and subdued investment and credit growth, there is a case for a cut in the policy rate today,” said RBI in its policy statement, adding the rate cut had been “front-loaded.”

At the press conference, Rajan added that RBI had erred on the side of investment while deciding on cutting interest rates as the economy continues to remain below potential. The potential growth rate for the economy under the new series is 8-8.5%.

As part of its policy, RBI also reduced its estimate for growth in the current fiscal year to 7.6% from 7.8% in its April policy. Reflecting the balance of risks and the downward revision to GVA (gross value added) estimates for 2014-15, the projection for output growth for 2015-16 has been marked down from 7.8% in April to 7.6% with a downward bias to reflect the uncertainties surrounding these various risks,” said RBI in its policy statement.

RBI noted that sustained weakness in consumption spending, especially in rural areas, continues to be a drag on the economy, adding that capacity utilization has also been falling in several industries. RBI also adjusted its estimated for inflation saying poor monsoon and higher global commodity prices could put upside pressure on inflation.

Assuming reasonable food management, inflation is expected to be pulled down by base effects till August but to start rising thereafter to about 6% by January 2016—slightly higher than the projections in April,” said RBI. In April, RBI had said that inflation is likely to be close to 5.8% by January 2016.

Consumer price inflation (CPI) fell to 4.87% in April, the lowest in four months. RBI has a CPI inflation target of 6% for the current year and aims to bring down inflation to 4% in the medium term. Following a monetary policy agreement signed with the government earlier this year, RBI is now formally an inflation-targeting central bank. Markets reacted negatively to the RBI’s policy. Equities fell and bond yields rose as some saw limited scope for further rate cuts.

Rising global oil prices and uncertain monsoon have tied the hands of RBI, said Murthy Nagarajan, head-fixed income, Quantum AMC. “Markets are expected to be range-bound with a slight selling bias, as RBI has increased the inflation forecast to 6% from 5.8%. Further movement in rates would be dependent on how the monsoon progress in the coming months.

Rajan said the RBI would announce new bank licences by the end of August this year. At the same time, he called for greater capital infusion into state-owned banks, which are already weighted down with stressed assets and, therefore, loathe to lend more to industry for fear of increasing such assets.