Monetary Policy | Third consecutive rate cut to support growth

Given the trajectory of growth and inflation, there still is room for another 25 bps cut over the next two meetings.

Gaurav Kapur

May 11, 2020 / 18:28 IST

RBI Governor Shaktikanta Das

Acting along expected lines, the Monetary Policy Committee (MPC) reduced the Repo rate by 0.25 percent to 5.75 percent—the lowest in the inflation targeting regime put in place in 2016. The decision to cut the rate was unanimous. The decision to change the forward guidance— policy stance – to accommodative from neutral was also unanimous, signalling more monetary easing ahead to support growth. The unanimity of decision is a clear indication that the concerns on the growth slowdown took precedence over any risks to the inflation target.

The RBI forecasts for inflation and real GDP growth underpinning these decisions were revised lower compared to their April level. As per the revised trajectory, CPI inflation is expected to remain below 4 percent throughout the current fiscal year with headline inflation seen in the range of 3 – 3.1 percent in the first half and 3.4 – 3.7 percent in the second half. The risks to this trajectory are seen as evenly balanced. The real GDP growth is seen a tad lower at 7 percent during FY20, compared to the April projection of 7.2 percent, with first-half growth between 6.4-6.7 percent and second half growth seen in the range of 7.2-7.5 percent. And the risks to this forecast too evenly balanced.

Given this trajectory of growth and inflation, there still is room for another 25 bps cut over the next two meetings. Any monetary easing beyond that would depend upon on growth underperforming and/or inflation undershooting and the extent of fiscal policy stimulus to support consumption and investment. On the growth front, the current cyclical slowdown to a rate well below the potential can prolong into the second half if private consumption growth remains muted. A key risk which feeds into this is the credit squeeze from the non-banking sector becoming more acute. The external sector, too, could add to growth drag if export growth weakens sharply on the back of slower global growth. The drag from the slowdown in investment activity is likely to prove short-lived, as with the new government in place, capex spending is likely to pick-up. The likelihood of growth remaining below 7 percent in the second half of the year, too, is low at this stage, especially given the policy stimulus.

On the inflation front, the main upside risk is from a monsoon shortfall, which could arrest the broad-based food disinflation seen over the last couple of years. Otherwise core inflation, after the rapid softening since October last year, is likely to stabilize around 4 percent. The policy statement notes that a sharp decline in core inflation due to weak demand has imparted a downward bias to the inflation trajectory for the year. Moreover, the recent easing in oil prices is yet to see a complete pass through. On balance, therefore, the upside risk to inflation from rising food prices is likely to be matched by lower core inflation and benign fuel price pressures. Thus, the headline inflation on average is expected to be around 3.3 percent, strengthening the case for more monetary easing going forward.

The RBI also announced that an internal working group is reviewing its liquidity management framework in order to simplify it and improve communication around it. The main objective of this framework is to ensure that the weighted average call rate is closely aligned to the Repo rate. In pursuit of that, the central bank uses a variety of instruments to manage liquidity. In order to improve communication around this framework, the working group may choose to provide a rule-based measure of an adequate level of liquidity, benchmarked to the banks’ net demand and time liabilities.