The Reserve Bank of India (RBI, the central bank) has played an instrumental role in ensuring macroeconomic stability in the past few years. It underwent important leadership and structural changes earlier this year, which were reflected in its monetary policy review published on October 4th. The RBI's newly installed monetary policy committee (MPC) sanctioned a 25-basis-point cut of the benchmark interest rate on account of weaker food price pressures and concerns over economic growth. The Economist Intelligence Unit believes that this decision will add to upside risks on inflation and will do little to spur ailing private investment.

Urjit Patel came into office as the new RBI governor in September amid much speculation about whether the central bank would change its monetary policy stance or other policies under his leadership. Later in the month the RBI witnessed a fundamental change to its decision-making processes. The government's appointment of three economists to the newly constituted six-member MPC meant that the final say over the benchmark interest rate, the repurchase (repo) rate, in October and at subsequent meetings would be determined by a group, rather than the just the RBI governor as in the past.

Mr Patel came into office with strong inflation-fighting credentials: he was instrumental in setting up the new decision-making regime. In addition, in its monetary policy review in August the RBI had noted that risks to its inflation target (set at 4% plus or minus 2%) were skewed to the upside. As a result, we had expected the RBI to stay pat at its October meeting. Moreover, we have long argued that the economic rationale for rate cuts is limited, as the primary reason for the slowdown in private investment is not high interest rates but the heavy debt burden weighing on corporate balance sheets and capital constraints in the banking sector.

The RBI bets on the monsoon

The new committee's unanimous decision to go ahead with a 25-basis-point rate cut, to 6.25%, therefore came as a surprise. The RBI believes that the robust harvest, combined with improvements on the supply side, will help to ease inflationary pressures arising from food prices in the months ahead. Indeed, in August the rate of consumer price inflation slowed to 5.1% year on year, from 6.1% in July, on account of a deceleration in food price inflation. The record harvest means that food price pressures in the months ahead should be fairly contained. As a result, the RBI forecasts that consumer price inflation will stand at about 5% in March 2017.

However, as the RBI once again noted in its monetary policy statement in October—and as we believe—risks to the inflation outlook remain tilted to the upside. The RBI's decision adds an upside risk to our forecast that consumer price inflation will average 5.1% in 2017. This is because, even before the rate cut, consumer expenditure growth was expected to accelerate markedly in the second half of fiscal year 2016/17 (April–March) thanks to increased wages and pensions for government employees, as well as higher spending in rural areas on account of a robust harvest. Although we do not anticipate that the interest-rate cut will lift private investment significantly, it could lead to a further acceleration in the growth rate of personal loans and mortgages. The RBI's cut could thus fuel consumer demand, and therefore stoke inflation, rather than lift private investment.

Reversed legacy

The MPC's unanimous decision signalled a small but important reversal from one of the legacies established under Mr Patel's predecessor, Raghuram Rajan. Mr Rajan was keen to lift the household saving rate and, as a result, aimed to keep inflation-adjusted interest rates between 1.5% and 2%. By contrast, the MPC appears comfortable with a lower real interest rate, of around 1.25%. In Mr Rajan's view, higher domestic savings channelled through the banking system were necessary in order to bolster investment sustainably. He believed that lowering interest rates would lead to savers shifting their money into hard assets such as gold or real estate. The reduced availability of savings in the domestic banking system in turn made India vulnerable to macroeconomic risks (through a wider current-account deficit), as investments would have to be increasingly funded with capital from abroad. A lower real interest rate signals a modest departure from Mr Rajan's legacy and means that the RBI is, on balance, willing to tolerate a slightly higher rate of inflation.

Monetary policy continuity Topic Policy under Mr Rajan EIU view on continuity under Mr Patel Inflation Launched implementation of 2-6% inflation target Yes, will follow inflation-targeting framework Efficiency of capital allocation Implemented banking sector reforms Yes, will continue in similar vein Bad loans Pursued bad loans less aggressively Partial, will ease the pressure on banks Currency Fought off political pressure for currency depreciation Partial, but in consultation with the Ministry of Finance Fiscal consolidation Pushed government to narrow budget deficit Partial, may lack political capital Bank recapitalisation Fought against bank recapitalisation using RBI capital Possible change Real interest rate Aimed for real interest rate of 1.5-2% No, comfortable with 1.25% Source: The Economist Intelligence Unit.

Cut unlikely to help investment

The RBI continued to cite the industrial production index (IIP) rather than national-accounts data on manufacturing growth. This is important as there is a strong divergence in IIP and national-accounts data, with the former indicating a contraction and the latter a strong expansion. We believe that both metrics have significant faults, but IIP data appear more in line with other high-frequency indicators. The RBI's continued neglect of the national-accounts data will lend further credibility to concerns that GDP data are overstating real economic growth.

Whereas the RBI argues that the interest-rate cut will help to lift credit growth to the industrial sector in the months ahead, we are much more cautious about the impact of the reduction. After all, the repo rate had been cut by a cumulative 150 basis points between January 2015 and April 2016 under Mr Rajan, with little positive impact on private investment and manufacturing (as per the IIP measure). This is partly because those rate cuts have not yet been fully transmitted on by banks to borrowers, suggesting that the RBI could have achieved its aim of accelerating corporate credit growth by incentivising banks to pass on past rate cuts fully.

A regulatory change (an easing of norms related to stressed assets on banks' balance sheets) announced on October 4th supports our view that Mr Patel will take a softer stance on bad loans than Mr Rajan. The RBI is aware that a key challenge facing India's industrial sector is an overhang of bad loans, which has diminished both loan supply and appetite for credit even as GDP growth is robust. We think that this change will help to reduce some pressure on banks' balance sheets but will do little to rekindle animal spirits in the corporate sector. Indeed, Mr Rajan's aggressive campaign against bad loans may have been one of the reasons why his term as RBI governor was not extended (and not his desire to return to academia, as officially stated).

We believe that a recapitalisation of struggling public-sector banks (where non-performing assets are disproportionally located) beyond the government's current plans would have a larger effect in reviving private investment (even as corporate deleveraging weighs on credit demand). However, the Ministry of Finance remains opposed to expanding recapitalisation funds, as it seeks to narrow the budget deficit to the equivalent to 3.5% of GDP in 2016/17. The RBI's decision to cut interest rates was greeted positively by domestic investors and companies, but we still believe that the onus for an improvement in the investment outlook rests more with the government than the central bank.