Three reasons why BofA-ML projects RBI rate cut in August

Bank of America Merrill Lynch (BofA-ML) expects the Reserve Bank of India (RBI) to cut key interest rates by 25 basis points in its Monetary Policy Committee meet on August 2.

Bank of America Merrill Lynch (BofA-ML) expects the Reserve Bank of India (RBI) to cut key interest rates by 25 basis points in its Monetary Policy Committee meet on August 2.

"We continue to expect the RBI monetary policy committee to pause on June 6 and cut rates by 25 basis points (bps) on 2 August," BofAML said in a report.

As per the report, the apex bank is most likely expected to wait for the transfer of the 'special' dividend to the fiscal from demonetisation and a good monsoon before they announce a cut.

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Previously, the RBI in its monetary policy review meet on April 6, kept the repurchase rate - rate at which it lends to banks - unchanged at 6.25 per cent but increased reverse repo rate to 6 per cent from 5.75 per cent.

Here are the three reasons why Bank of America Merrill Lynch expects a rate cut in August:

1. Weak growth

BofAML's long standing that lending rate cuts are the key to economic recovery is in contrast to RBI's concern that a rate cut could see a gradual closing of output gap - the amount by which the actual output of an economy falls short of its potential output.

This would eventually lead to aggregate demand pressures setting off an inflation trajectory.

According to BofAML's trend analysis, old series GDP growth which is at 4.5-5 per cent falls below the bank's estimate of 7 per cent.

Additionally, metrics like industrial production, credit growth and corporate earnings are below their medium-term averages.

Investment has collapsed to 28.7 per cent of GDP from 32.7 per cent in March 2014, indicating a slump in the system.

2. Amiable inflation

Inflation rates have averaged to 4 per cent, well within the Reserve Bank's 2-6 per cent mandate for the first half of 2017.

While the Australian weather bureau forecasting a 50 per cent chance of El Nino this year, the MeT department have projected 96 per cent normal rainfall.

Further, expectations of a good yield in oilseeds, pulses and rabi corps are seen to pull prices down.

This indicates food inflation easing out in the coming months.

Additionally, BofAML also highlights a second round of inflationary effect of higher house rent allowances post payoff of the 7th Pay Commission arrears in October.

Earlier, core inflation fell from 4.8 per cent in March to 4.2 per cent in October when the RBI cut rates by 25 bps.

Which such an inflation, a rate cut can be seen around the corner.

3. Need for more Forex reserves

A rate cut will help the central bank to regain forex reserves by attracting Foreign Portfolio Investment (FPIs) in equities which will help to push up growth numbers.

Bank of America expects the RBI to continue to buy forex reserves in a bid to insure against global volatility as well.

The bank, further, projects RBI Governor Urjit Patel to bet on forex reserves after FPIs surged about 120 per cent of forex reserves from only 80 per cent against in the year 2007-08.

On the Indian rupee, Bank of America attributes 'seasonality' as a factor that will depreciate the currency.

"Our Asia forex strategists see Rs 66.75/USD by December," said the report.

The Indian rupee touched 21-month high of Rs 64 against the US dollar, gaining over 5 per cent against the greenback in this year.

Even a Reuters poll report forecasted the Indian rupee to weaken to 66.23 per dollar in the year, a more than 3 percent fall from where it was trading recently at 64.22 on the back of US Federal Reserve's tip of possible rate hikes in the coming months.