The Reserve Bank of India has already slashed its repo rate — or the rate at which it lends to commercial banks — by 135 basis points since January to boost the economy, making it one of the most aggressive central banks at the moment. The current repo rate is 5.15%.
Still, the cumulative rate cut and "ample surplus liquidity in the banking system" resulted in only a 60-basis-point reduction in lending rates for fresh loans and much lower for all outstanding loans, according to Citi analysts Samiran Chakraborty and Baqar M Zaidi.
"This lack of transmission has raised serious questions about the effectiveness of monetary policy transmission in an environment of acute risk aversion and other structural rigidities but it will be difficult for any central bank to admit that," they wrote in a note this week.
Economists on average predicted the RBI to cut its repo rate by 25 basis points to 4.90% this week and then by another 15 basis points in the second quarter of 2020, Reuters reported.
Theoretically, when a central bank cuts lending rates to commercial banks, those lenders would pass on the rate cuts to consumers in the form of cheaper loans. But, many lenders in India are struggling with large volumes of non-performing assets weighing on their balance sheets. That makes them hesitant to pass on the full benefits of lower cost of borrowing to consumers.
"Policy transmission impeded by credit back-up and liquidity risks in the banking and shadow banking sectors question the efficacy of further rate cuts, which come at an increasing cost to rupee and macro stability," Vishnu Varathan, head of economics and strategy at Mizuho Bank, wrote in a Monday note.
That said, the RBI in September made it mandatory for banks to link certain categories of loans to an external benchmark system to determine interest rates for consumers. Banks that use the RBI's repo rate as the benchmark would then have to adjust their lending rates according to the central bank's subsequent moves.
A close reading of India's headline growth number for the three months to September showed public expenditure helped bolster the overall GDP number.
But, the government is running out of room for continued spending to pump up the economy, according to Kunal Kundu, India economist at Societe Generale. Adding to that, "tax revenue collection (is) likely to be rather underwhelming given that nominal GDP growth has dropped to its lowest ever, a worsening of the eventual fiscal deficit remains a distinct possibility," he said in a recent note.
The budgeted fiscal deficit target at the moment is 3.3% of GDP and if it widens too much, then investor confidence could take a hit. Recently, ratings agency Moody's downgraded its outlook on India from "stable" to "negative."
"With the government lacking the fiscal space to pump prime the economy, we think that the RBI's policy easing stance is likely to continue despite the discernible lack of efficacy," Kundu wrote, adding that he expects the central bank to reduce rates further by 50 basis points for the full fiscal year, including a 25 basis point cut this week.
While monetary easing has yet to produce the kind of results policymakers in India are hoping for, inflation is becoming an apparent problem. The RBI's medium-term inflation target till 2021 is 4%, with lower and upper tolerance limits being 2% and 6%, respectively. But, India's annual retail inflation rose to 4.62% in October on the back of higher food prices, Reuters reported.
Slowing growth and rising inflation leaves the RBI on a "precarious tight rope," Mizuho's Varathan said, adding that the inflation flare-up is largely a supply-side issue driven by rising food prices that "does not require a strong policy response."
"But the optics of perceived indifference or worse, disregard (unabated cuts), amid rapid inflation rebound is non-ideal," he said. "Precisely why we had advocated a larger rate cut earlier before the window of opportunity narrowed."
As such, the RBI's expected rate cut will compromise the stability of the Indian rupee and the wider macroeconomic environment, Varathan explained. The central bank's policy dilemma "will only intensify near-term as growth pressures are set to persist and food-led inflation looks poised to pick-up."
Citi analysts Chakraborty and Zaidi added that the RBI needs to monitor fluctuations in food prices, particularly vegetable prices, for a few more months and check "whether these are feeding into household inflation expectations."
"Maintaining the 'accommodative' stance and keeping the door open for a future rate cut is going to be the most difficult challenge for the (RBI)," the Citi analysts added.