Apart from offering a support to the economy, we think the larger-than-usual cut serves as a tactical move to pressure 1) the banks to pass on policy easing and 2) the government to speed up supplyside reforms. Prior to today’s action, the RBI had eased policy by 75bps between Jan and Jun. While money and bond markets have responded well, banks have passed on less than half of the rate cut (e.g. 30bps). Given the stiff monetary transmission, the RBI has decided to frontload the rate cuts today to generate a larger pass-through.
In addition, by answering the call from the country’s Finance Minister to ease monetary policy, the RBI now puts the ball back in the government’s court, pressuring the latter to speed up supply-side reforms. With the frontloading of rate cuts, we now expect the RBI to keep its policy on hold for the rest of 2015. The focus for the central bank will now shift to achieving 5% inflation in 2016-17. A backward calculation based on recent RBI speeches suggests that the central bank wants to target a level of real interest rate at 150-200bps. With 5% inflation, this will give a nominal rate of 6.5-7% in 2016-17, meaning that the scope for further easing is limited. However, we think the risks on inflation are to the downside, given the continued impact of lower commodity prices and economic reforms removing supply bottlenecks. We hence think the RBI will maintain an easing bias in 2016.