Rajesh Kumar
As expected, the monetary policy committee (MPC) of the Reserve Bank of India (RBI) decided to reduce the policy rate by 25 basis points. It has done well by maintaining a neutral stance. A shift in stance to accommodative would have fuelled expectations of deeper cuts in the market. As a result, the decision turned out to be a non-event for financial markets with both equity and bond markets remaining largely flat. The decision was already priced in.
However, the question that the market would now be debating is: what next for the MPC?
The path from here on will depend on how a variety of factors play out and affect inflation projections. First, both the global and domestic economy is showing signs of a slowdown. The fear is that the US might slow down significantly, if not slip into a recession. The European Central Bank has cut the current year growth forecast for the region. As the MPC also noted, the Italian economy has contracted for two quarters in a row. Growth in China is also expected to soften. But, while the slowdown in global growth would lead to weaker demand and lower prices, policy accommodation by large central banks could keep commodity prices somewhat elevated.
In the Indian context, the MPC expects growth to slow to 7.2 percent in the current financial year, compared to its earlier projection of 7.4 percent. Therefore, the Indian central bank will need to gauge how the combination of these factors actually plays out in terms of their impact on inflation outcomes.
Second, while a lot will depend on the next government, the general sense is that the fiscal policy is likely to get more accommodative. In fact, revenue is likely to have fallen short of target in the last financial year, which ended a few days ago. In this context, the MPC in its resolution noted: “…fiscal situation at the general government level requires careful monitoring.” Therefore, monetary policy might need to do a balancing act in order to keep inflation and inflationary expectations in check.
Third, although the rate-setting committee does not expect the headline inflation to cross the 4 percent mark—the midpoint of the target range— in the current financial year, core inflation remains a source of concern. Core inflation continues to remain above the 5 percent mark, though there has been some softening in recent months. Since inflationary expectations have a bearing on the actual outcome, it is important to understand how core inflation affects inflation expectations. As economist Sajjid Z Chinoy has shown, core inflation affects household inflation expectation three times more than food inflation. So, the sticky nature of core inflation would warrant caution. Excessive accommodation on the basis of lower headline inflation due to softer food prices could backfire after a point. In fact, the possibility of less-than-normal monsoons would potentially push food prices up.
Therefore, there are a number of factors that will come into play when the MPC meets to deliberate on monetary policy next time in June. There will also be a new government in office by then and, possibly, both the MPC and markets would have more clarity on the fiscal trajectory.
However, on balance, it can be argued that this is not the end of the easing cycle. Apart from the rate cut, the market will be interested to see if it actually gets transmitted into the system. For this to happen, it will be important to track how the central bank manages the liquidity situation and the fiscal stance of the new government, which will present a full budget in July. A fiscal slippage will only complicate matters for the central bank. Meanwhile, although the State Bank of India, the largest lender in the country, has linked interest rate on its saving deposit above 1 lakh to the repo rate, it remains to be seen how it actually affects lending rates.
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