On Thursday, government reported headline inflation at 7.55 per cent in May, in line with expectations, which however, under ordinary circumstances would keep the RBI focused squarely on controlling prices.
However, GDP growth slipped to a nine-year low of 5.3 per cent in the March quarter, and industrial production was flat in May, data this week showed, adding to a sense of urgency about the deteriorating state of the economy.
A Reuters poll last week showed most economists expect a repo rate cut, but few expected a cut in the cash reserve ratio, the share of deposits that banks keep with RBI. Expectations have grown since then for a CRR cut.
The RBI will release its mid-quarter monetary policy review at 11 am on Monday, and there is a broader-than-usual range of expected outcomes, according to the predictions of traders and economists.
Possible scenarios:
25 BASIS POINTS CUT BOTH IN REPO RATE AND CASH RESERVE RATIO: Probability: One of two most likely outcomes.
Many market participants are betting on a modest reduction in both the repo rate and CRR because the combination of interest rate and liquidity easing would send a signal that the RBI is keen to prop up growth by providing liquidity to banks while ensuring inflation is under control. An easing in core inflation to around 4.85 percent in May may give the central bank comfort to cut rates.
Such an action would compel banks to cut lending rates as improved cash flow brings down their cost of deposits, which has remained high despite the RBI's previous rate and CRR cuts. The market also expects the RBI to sound pro-growth in its statement, and at the same time highlight inflation risks.
Market reaction: Government bond yields and interest rate swaps could ease 5-7 basis points and the curves may shift downwards. The rupee may rise marginally, with s t ocks posting modest gains.
25 BASIS POINTS CUT IN REPO RATE, NO CRR CUT: Probability: One of two most likely outcomes.
The RBI may decide only to reduce rates but refrain from infusing more market liquidity, as it is already injecting cash into the system through bond purchases and may prefer to save the CRR tool for when liquidity tightens sharply. High food prices and consumer price inflation continue to pose risks to inflation and the RBI may not be comfortable turning dovish.
However, only a repo rate cut may not be enough to spur banks to cut lending rates, or to improve sentiment sufficiently to bolster growth.
Market reaction: Given that markets have already priced in a 25 basis point rate cut, such a mild step could disappoint investors and push up bond and swap rates.
NO REPO RATE CUT, 50 BASIS POINTS CUT IN CRR Probability: Less likely
To improve monetary policy transmission, the RBI could choose only to reduce the CRR, which would release liquidity and bring down banks' cost of funds immediately, enabling them to reduce lending rates. Many view a reduction in CRR as a more effective tool than a rate cut.
The RBI has been under increasing pressure to cut the CRR after finance ministry officials and the country's largest state bank have called for one.
The RBI may be reluctant to cut CRR by such a big margin, however, that could fuel inflationary pressures.
Market reaction: Government bond and swap curves could steepen with short-end rates softening as cash pressures ease. Concerns that a steep CRR cut could prompt the RBI to avoid bond purchases could keep long-end rates elevated.
25 BASIS POINTS CUT IN REPO RATE, 50 BASIS POINTS CUT IN CRR: Probability: Less likely
Some investors hope the RBI turns actively dovish, betting that a big CRR cut accompanied by a rate cut ensures effective monetary policy transmission. With mounting pressure on the RBI from the government, some in the market believe the RBI may take the plunge and release an aggressively pro-growth policy.
Market reaction: Short-end government bonds and swap rates would ease more than the long-end. The rupee and stocks could post gains.
NO CHANGE IN RATES OR CRR Probability: Unlikely
With a sagging economic growth, moderate core inflation, and increasing pressure from the government, it is unlikely that the RBI does nothing, as a downturn in domestic and global economic conditions has spurred calls for central bank action. Until a few weeks ago, the majority view was that the RBI would keep rates and CRR on hold at its June review.
Market reaction: There would be sharp sell off across all asset classes.
(Source- http://economictimes.indiatimes.com)
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