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Monetary Policy: Rajan cuts repo rate but says risks to inflation persist

Rajan said that inflation could cloud the picture and identified three possible risks.

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RBI governor Raghuram Rajan
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Reserve Bank of India (RBI) has brought down repo rate by 25 basis points in its second bi-monthly monetary policy this year. 

The key rate now stands at 7.25% with immediate effect as against 8% at the beginning of the year and 7.5% before today. 

Raghuram Rajan, governor, RBI said that the low domestic capacity utilisation, still mixed indicators of recovery, and subdued investment and credit growth makes a case for a rate cut. 

On inflation, he said that inflation is expected to start rising after August 2015 to about 6% by January 2016 -- slightly higher than the projections made by RBI in April. He said, "Putting more weight on the IMD’s monsoon projections than the more optimistic projections of private forecasters as well as accounting for the possible inflationary effects of the increases in the service tax rate to 14%, the risks to the central trajectory are tilted to the upside." 

Rajan said that inflation could cloud the picture and identified three possible risks. 

Rajan said, "First, some forecasters, notably the IMD, predict a below-normal southwest monsoon." He said that astute food management is required to mitigate the possible inflationary effects arising out of below-normal monsoon. 

Secondly, he cautioned about crude oil prices firming up amidst considerable volatility and geo-political risks are every present. "Third, volatility in the external environment could impact inflation," he said. 

Explaining his rationale to cut repo rate, Rajan said, "Therefore, a conservative strategy would be to wait, especially for more certainty on both the monsoon outturn as well as the effects of government responses if it turns out to be weak. With still weak investment and the need to reduce supply constraints over the medium term to stay on the proposed disinflationary path (to 4% in early 2018), however, a more appropriate stance is to front-load a rate cut today and then wait for data that clarify uncertainty." 

Rajan, however, asked banks to pass on the benefits of this rate cut to the customers. He said, "Meanwhile banks should pass through the sequence of rate cuts into lending rates." 

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