The Reserve Bank of India (RBI) essentially lived up to the market's expectations, if not the government's, by reducing neither the repo rate nor the cash reserve ratio. The decision could be viewed as being somewhat contrarian, given that the latest inflation reading was within the RBI's comfort zone, providing it some basis for shifting its emphasis towards the rather worrisome growth situation. However, the RBI has observed that, as a consequence of the movements in the rupee over the past few weeks, inflation risks that appeared to be abating have reappeared. Also, there was little comfort on the retail inflation front. Finally, the RBI obviously continues to believe that it is unclear how much stimulus a small reduction in the policy rate can provide for demand, particularly investment, when there are so many other constraints at work. For the central bank, inflation risks clearly trumped growth payoffs.
The question that obviously arises is: what next? Over the past three years, the monetary policy cycle has witnessed pauses on two occasions. In December 2010, the RBI paused before resuming its tightening cycle in January 2011. Subsequently, after having surprised observers with a reduction of 50 basis points in the repo rate in April 2012, there was a relatively long pause until January 2013, when the rate reductions resumed. Going by these two precedents, yesterday's pause does not in and of itself signal that the rate cutting cycle has ended; further cuts could be in the offing, presumably when some of the factors that contributed to this decision reverse or, at least, become less significant. Should potential borrowers and investors, then, build up expectations of a resumption in the cycle in the quarterly review due on July 30?
Putting the inflation projections made in the annual policy statement of May 3 together with the guidance provided in yesterday's mid-quarter review, this expectation may be unwarranted. In the annual statement, which preceded the recent decline in the rupee, the RBI indicated that it expected inflation to firm up in the second half of the year. After this depreciation, that projection can only be reinforced. The guidance provided in yesterday's review indicated that the RBI would look for a "durable receding of inflation" to justify further rate reductions. Since its own projections, particularly after the recent rupee depreciation, don't suggest that there will be a durable receding, the reduction of 25 basis point in the repo rate on May 3 might well have been the last one in this cycle. If so, this has two significant implications. One, the responsibility of reviving growth now rests exclusively on the government, which must then focus on de-clogging the investment pipeline. In this regard, the Cabinet Committee on Investment, much hyped, has so far been a disappointment. This was implicitly admitted to last week when the setting up of yet another special cell to monitor progress on large projects was announced. Two, further shocks to the currency, which precipitate relatively quick and large depreciation, will aggravate inflationary pressures. Would these induce the RBI to increase the repo rate, notwithstanding the sluggishness in growth? The already limited room for monetary stimulus may have become even smaller.