The expectations of rate cut were built up after the dismal 5.3% GDP reading for Q4FY12 amidst sticky headline inflation for May at 7.55%. However, RBI in its mid policy review has emphasized that its focus on inflation control remains unchanged, by having a status quo on the policy rates.

Background of the policymaking

Since the Reserve Bank's Annual Policy statement in April, global macroeconomic and financial conditions have deteriorated. At the same time, the domestic macroeconomic situation too raises several deepening concerns. While growth in 2011-12 has moderated significantly, headline inflation remained above levels consistent with sustainable growth. Importantly, retail inflation is also on an uptrend.

The Reserve Bank had frontloaded the policy rate reduction in April with a cut of 50 basis points, based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives. RBI has noted that slow down in the economy is a consequence of various factors – main among them being low investments and decline in Industrial production. It has also asserted that high interest rates has relatively small role on slackening economic growth. Thus it has accentuated that any further reduction in the policy interest rate at this juncture, could exacerbate inflationary pressures rather than supporting growth.

India's IIP grew by mere 0.1% in April 2012, and exports actually fell by 4.16% to US$ 25.68 billion in May 2012. Neither the domestic nor the global situation is conducive for economic growth. On the flipside, Inflation is well above projected levels and has increased to 7.55% for May 2012. The sharp depreciation of Indian rupee will add to inflation. Also, the prices of diesel, domestic LPG and Kerosene remains suppressed relative to the current price, and when the government decides to hike them, it win fan direct and indirect (through hike in transport cost and thereby hike in prices of goods too) inflation.

Touching on implication of rupee depreciation, RBI has noted that the domestic producers have gained in competitiveness over foreign producers. Over time this should result in expanding exports and contracting imports, thus acting as a demand stimulus.

Gilts market has factored in possible 25 bps cut in repo rate; higher net supplies of dated securities in the rest of H1FY13 without major redemption inflows will impact yields The yield on most traded 10-year benchmark federal paper, 8.79% GS 2021, dipped 16 basis points to three months low of 8.34% in the period under review (16 May -15 June 2012), snapping consistent increase for previous four sequential months by 03 bps, 11 bps, 16 bps and 01 bps, respectively. Bond market participants were widely expecting reduction in interest rate from RBI

The major reason for unchanged rates / CRR: inflation

India' WPI inflation surged to 7.55% in May 2012, while the inflation figure for March 2012 was sharply revised upward to 7.69% from 6.89% reported earlier. The inflation for May 2012 increased above market expectations of 7.4%.

Retail inflation moved up marginally to 10.36% in May on account of increase in prices of vegetables, edible oils and milk. Based on the Consumer Price Index (CPI), the inflation for April was revised to 10.26% from the provisional estimate of 10.32%.

Fall in global energy prices

We have not received gains from falling crude prices due to depreciation in the rupee. This means that our import bill is not really coming down. Also, if central banks in Europe and US decide to go in for another round of monetary easing, commodity prices could again shoot up.

RBI on liquidity

To encourage banks to increase credit flow to the export sector, the RBI has increased the limit of export credit refinance from 15 per cent of outstanding export credit of banks to 50 per cent, which will potentially release additionally liquidity of over Rs 30,000 crore, equivalent to about 50 basis points reduction in the CRR. The interest on ECR facility will be the prevailing repo rate, which is 8.0% at present.

But a CRR cut would have been more superior for banks, as it will not only inject liquidity in the system, but will also reduce interest costs to the banks. This is due to the fact that amount parked as CRR donot bring any interest income to banks, and any cut in CRR unleashes not only liquidity, but will also reduce the interest cost / improve net interest income, of the banks.

Lots of uncertainty in near term forced RBI

The monsoon is key for interest rate decision. The quarter policy review scheduled to release in July 2012. A fair idea on average rainfall can be known by the end of July. This data is critical to projected future inflation. By then, clouds of uncertainty on global macro economy will get clear in few grounds. The political Diasporas is the other side of the same coin. The new finance minister will take charge in few weeks. The change in the guard will have impact on policy making. It is not essential for RBI to take views from finance ministry before mid quarter policy review but it is a case for quarter policy review.

At this background, we can expect reduction in interest rate / CRR in RBI policy schedule to release in July 2012.

RBI prefers to wait for more cues

The time factor has played critical role in today's RBI policy. There are many domestic and global macro economic and political issues moving towards unknown direction. The proper direction of these suspicious moments will decide the stance of the RBI‘s policy scheduled to be released in July 2012.

Guidance from RBI

The evolving growth-inflation dynamic will continue to influence the Reserve Bank's stance on interest rates. Core inflation has moderated, reflecting demand conditions and lower pricing power. However, both headline and retail inflation rates are rising, which have a bearing on inflation expectations. Future actions will depend on a continuing assessment of external and domestic developments that contribute to lowering inflation risks.

Management of liquidity remains a priority. Even as the liquidity situation converges to the comfort zone, the Reserve Bank will continue to use OMOs as and when warranted to contain liquidity pressures.

Finally, recognizing that the global situation is turbulent, the Reserve Bank stands ready to use all available instruments and measures to respond rapidly and appropriately to any adverse developments.

Fitch India too cuts India's outlook to negative

Two rating agencies – Standard & Poors, and today (18^th June 2012), Fitch Ratings have cut India's outlook from stable to negative. Fitch ratings warned that a significant loosening of fiscal policy, which leads to an increase in the gross general government debt/GDP ratio, would result in a downgrade of India's sovereign ratings. Further, material downward revision of Fitch's assessment of the India's medium-term growth potential along with persistent high inflationary pressure would hurt India's sovereign creditworthiness. Conversely, an improvement in India's investment climate, which supports greater infrastructure investment and a sharp sustained decline in inflation, would be supportive for India's sovereign ratings. Fiscal consolidation and structural budget reform would also support the ratings.

RBI has decided to focus on headline inflation – both WPI based and CPI based inflation and slightly overlooked core inflation. Especially as India is yet to revise the prices of diesel, domestic LPG and Kerosene. Though growth is sluggish, RBI indicated that there are many factors, other than interest rates, that are contributing more significantly to the growth slowdown.

The sharp depreciation of Indian rupee will mean possibly another round of increase in various manufactured product prices. So, the current relatively benign core inflation cannot be taken at face value. Perhaps the focus now shifts on how soon, and how effectively the government takes various fiscal measures to bring back Indian economy to better growth path, amidst global uncertainties.