Monetary Policy | Additional rate cuts are not off the table

Aditi Nayar

With a further widening of the output gap, the Monetary Policy Committee (MPC) reduced the repo rate by 25 basis points (bps) to 5.15 percent in the October 2019 policy review. With this, the benchmark rate has been cumulatively cut by a substantial 135 bps over the five consecutive policy reviews in 2019.

The considerable loss of economic growth momentum remains the chief policy focus amid a relatively benign inflation outlook. The decision to reduce the policy rate and maintain the stance as accommodative was unanimous although one of the six MPC members voted for a larger rate cut of 40 bps.

The cut of 35 bps in the August policy had opened up the possibility of another reduction of an unconventional magnitude in the October review. However, the MPC cut the repo rate by a standard 25 bps, in line with our expectations.

The big change has been in the MPC’s forecast for economic growth in 2019-20, which has been reduced sharply to 6.1 percent (with risks evenly balanced) from the 6.9 percent (with risks to the downside) that had been projected two months ago. Moreover, the growth forecast for Q1 2020-21 has been revised to 7.2 percent, from 7.4 percent earlier.

The paring of the GDP growth forecast was inevitable following the surprisingly weak economic growth in Q1 FY20, and the disappointing trends revealed by various high frequency indicators for August as well as the just-concluded month. For instance, the YoY decline in the output of Coal India has worsened to 10.3 percent in August and further to a sharp 23.6 percent in September, from 5.1 percent in July. Furthermore, wholesale despatches by a number of original equipment manufacturers (OEMs) remained sluggish in September.

The MPC remarked that monetary transmission has been staggered and incomplete, with the weighted average lending rate (WALR) on fresh rupee loans of commercial banks easing by only 29 bps even as the WALR on rupee loans outstanding rose by 7 bps, in contrast to the total 110 bps decline in the policy repo rate during February-August.

The transmission of monetary easing undertaken so far is expected to improve, going forward. The impact of the same would be complemented over the medium term by the growth-enhancing measures announced by the government.

However, an immediate revival in investment activity may prove elusive, in our view, especially given that capacity utilisation levels remained moderate at 73.6 percent in Q1 FY20. Moreover, export growth may remain anaemic in the current global scenario. Nevertheless, the waning of the unfavourable base effect is likely to result in higher economic growth in the last three quarters of 2019-20, relative to the low 5 percent recorded in Q1.

With the recent hardening in vegetable prices likely to prove temporary, the MPC has only revised its CPI inflation forecast for Q2 FY20 to 3.4 percent from 3.1 percent while the estimates for H2 FY20 and Q1 FY21, have been retained at 3.5-3.7 percent and 3.6 percent, respectively, with risks evenly balanced, despite the impact of the policy rate cuts and rising inflationary expectations of households.

The MPC remarked that the outlook for food inflation has improved since the August policy review. While the first advance estimate of kharif output is similar to the previous year’s level for some crops, we are apprehensive that the late surge in rainfall, flooding in various states and the delayed withdrawal of the monsoon may have damaged the standing crops.

The MPC highlighted that the sobering impact of the subdued global growth outlook would keep prices of commodities, including crude oil, in check. Moreover, weakness in domestic demand as well as the pricing power of producers would restrain inflation in output prices. However, the rate-setting committee underscored the impact of volatility in emerging market currencies, which may modestly add to imported inflation.

The MPC’s decision to retain the accommodative stance for as long as necessary to revive growth suggests that further rate cuts may be forthcoming. In our view, the GDP growth for Q2 FY20, which will be published shortly before the next MPC review, would critically drive the timing and magnitude of the next repo rate cut.

Aditi Nayar is Principal Economist, ICRA. Views are personal.