Monetary Policy | Inflation, transmission issues took rate cut off the table

Aditi Nayar

Contrary to expectations, the Monetary Policy Committee (MPC) kept the repo rate unchanged at 5.15 percent in the December 2019 policy review, in a unanimous decision. The sharp upward revision in the CPI inflation projections outweighed the concerns related to economic growth.

Moreover, the delayed and incomplete transmission of the cumulative repo rate cuts of 135 bps, particularly to bank lending rates and small savings schemes, as well as the measures to support growth that may be announced in the upcoming Union Budget, prompted the Committee to pause. Nevertheless, the MPC reiterated that the stance will remain accommodative as long as it’s necessary to revive growth, which suggests that a further rate cut should not be ruled out.

The sharp rise in the retail inflation in October 2019, led by the temporary flare-up in vegetable prices, as well as an increase in prices of protein items and sugar which may prove to be more enduring, has been accompanied by a hardening of households’ inflation expectations. Accordingly, the MPC has significantly increased its CPI inflation forecast for H2 FY20 to 5.1-4.7 percent from the earlier 3.5-3.7 percent, with risks broadly balanced.

Notably, this is appreciably higher than the mid-point of the Committee’s medium-term target for CPI (consumer price index) inflation of 4 percent +/-2 percent. Subsequently, the MPC expects the CPI inflation to ease in H1 FY21 to 4.0-3.8 percent, with risks broadly balanced, although the trajectory is now higher than the earlier forecast.

Following the continued drop in GDP (gross domestic product) in Q2 FY20, the MPC has considerably reduced its projection for economic growth for the year to March to 5 percent, from the previous 6.1 percent with risks evenly balanced in October 2019. Although the Committee highlighted that there are early signs of a recovery in investment activity, it expects only a mild uptick in growth from 4.8 percent in H1 FY20 to 4.9-5.5 percent in H2 FY20, and further to 5.9-6.3 percent in H1 FY21.

At present, there is mixed evidence of how the economic growth momentum is evolving in Q3 of 2019-20. On the one hand, core sector output recorded a deep contraction in October, weighing on various indicators of freight. Moreover, the government’s expenditure growth decelerated in that month. However, non-oil merchandise exports, petrol and ATF (aviation turbine fuel) consumption, and domestic airlines’ passenger traffic recorded an improved year on year (YoY) performance in October relative to the trend in September.

The improvement in certain activities such as mining and construction that have been constrained by heavy rainfall, a waning of the unfavourable base effect in some sectors such as automobiles and a gradual improvement in sentiment should lead to some pick-up in GDP and GVA (gross value added) growth in October-March of this fiscal. However, a sizable shortfall in revenue receipts may trigger expenditure cuts or deferral by central and state governments towards the end of this fiscal year. This would dampen a major driver of economic growth, as was highlighted in the GDP data for the September quarter.

Overall, there should be greater clarity on the evolving growth dynamics by the next policy review in February 2020.

In our view, the CPI inflation will print at uncomfortably high levels in November-December 2019, at well above 5 percent, led by food inflation and the recently announced hike in telecom tariffs. As a result, there appears to be a high likelihood of another pause in the February 2020 policy review.

Given the explicit statement that there is monetary policy space for future action, the MPC may reduce the repo rate by another 25 bps in 2020-21. However, this is expected only after there is visibility that the headline CPI inflation will sustain below 4 percent. In the meantime, the focus is likely to remain on improving transmission of the past repo rate cuts to bank lending rates.

Following the unexpected pause, the 10-year G-sec yield has risen by around 15 bps to 6.61 percent. For the rest of this month, we expect fiscal concerns, particularly the looming shortfall in the Centre’s tax revenues, to keep yields elevated at 6.5-6.7 percent. Any announcement of a change in the government’s borrowing calendar for Q4 FY20 will dominate the outlook for bond yields for the remainder of this fiscal.

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