Will the Reserve Bank of India Further Cut the Policy Rate?

India currently is a goldilocks economy and the envy of the rest of the world. The Indian economy expanded 7.3 percent year-on-year in the last three months of 2015, slowing from an upwardly revised 7.7 percent growth in the previous quarter but in line with market expectations. Consumer prices increased 5.18 percent year-on-year in February of 2016, lower than 5.69 percent in January and below market expectations of 5.6 percent. More importantly, since the Reserve Bank of India (RBI) and the Ministry of Finance agreed in February 2015 to institute an inflation target of 4 percent increase in the Consumer Price Index (CPI) plus or minus 2 percent, inflation has hewed to the target range of 2-6%. In 2013, the CPI replaced the wholesale price index (WPI) as a main measure of inflation. Then, to spur growth even more, will the RBI cut the policy rate again, as seems to be the expectation of the Indian government, after cutting the repo rate four times by a total of 1.25 percent in 2015 to 6.75%?

The governor of the independent central bank – RBI – Raghuram Rajan, has laid out his conditions to the Indian government about what it will take for him to further lower the policy rate to support investment and, hence, growth. This was before Finance Minister Arun Jaitley presented his budget for fiscal year 2016-17 to the parliament. Rajan’s message was that India needs structural reforms that raise government spending in some areas to boost growth while holding back spending in other areas to keep the budget deficit under control. Fiscal rectitude, inflation control, reducing subsidies on fuel and food, increase in spending on infrastructure and other government programs such as swach bharath and Digital India, and making it easier to do business in India for attracting capital inflows to make programs such as Make in India successful would, according to Rajan, indeed be a recipe for sustained growth of the Indian economy where less expensive capital from the central bank can be put to productive use.

In the budget Jaitley delivered what Rajan wanted, at least partially but in important areas: India’s fiscal deficit will stick to the target of 3.9% for FY 2016-17 and to 3.5% for the following year. The Indian budget has increased infrastructure spending, reduced subsidies on oil (convenient given the current low oil prices. Reducing agricultural subsidies would be politically difficult.), allocated funding for swach bharath and has tweaked tax and investment policies to make it attractive for foreigners to invest in infrastructure, Digital India and Make in India initiatives.

The February 2nd Sixth Bi-monthly Monetary Policy Statement of 2015-16 says “[g]oing forward, under the assumption of a normal monsoon and the current level of international crude oil prices and exchange rates, inflation is expected to be inertial and be around 5 per cent by the end of fiscal 2016-17.” There is, however, some uncertainty that could affect this forecast if the assumption does not hold true.

The RBI may wait to ensure that the monsoon season is normal, assuming approximately status quo conditions on crude oil prices and exchange rates, before cutting rates again. Therefore, the policy rate may not be cut until August 2016, until after the coming of the monsoon.