RBI governor Urjit Patel and MPC (Monetary Policy Committee) surprised everyone by not cutting the repo rate. It seemed to be a foregone conclusion for most economists and analysts that MPC has a compelling case for a rate cut. After all, with global agencies cutting India’s GDP growth projection post demonetisation and inflation being well within the central bank comfort zone, what possible reason could the MPC have to not reduce repo rate? But the MPC has its own reasons and they are related to the uncertainty emanating from impact of demonetisation on growth and the possible upside risks to inflation.
“While supply disruptions in the backwash of currency replacement may drag down growth this year, it is important to analyse more information and experience before judging their full effects and their persistence – short-term developments that influence the outlook disproportionately warrant caution with respect to setting the monetary policy stance. If the impact is transient as widely expected, growth should rebound strongly,” says the policy statement. MPC is of the view that it is appropriate to look through the transitory but unclear effects of the withdrawal of SBNs (specified bank notes) while setting the monetary policy stance. We take a look at two factors that RBI and MPC has elaborated on:
1) Upside risks to inflation: According to the policy statement, the Committee took note of the upturn in the prices of several items that is masked by the easing of inflation on base effects during October. “Going forward, base effects are expected to reverse and turn unfavourable in December and February…If the usual winter moderation in food prices does not materialise due to the disruptions, food inflation pressures could re-emerge. With the OPEC’s agreement to cut production, crude prices may firm up in the coming months…Global developments, especially as financial markets factor in the future stance of US monetary and fiscal policy, could impart volatility to the exchange rate thereby feeding into inflation,” RBI notes.
According to MPC, the withdrawal of SBNs (specified bank notes) could result in a possible temporary reduction in inflation of the order of 10-15 basis points in Q3. Taking these factors into account, headline inflation is projected at 5% in Q4 of 2016-17 by the MPC. The risks are tilted to the upside but lower than in the October policy review, RBI says. “The fuller effects of the house rent allowances under the 7th CPC award are yet to be assessed, pending implementation, and have not been reckoned in baseline inflation path,” RBI said.
2) GDP growth: Even though the RBI has revised downwards its GDP and GVA growth projections for the current financial year, the statement suggests that the MPC and rhe central bank do not expect a long lasting impact of the demonetisation step. “The outlook for GVA growth for 2016-17 has turned uncertain after the unexpected loss of momentum by 50 basis points in Q2 and the effects of the withdrawal of SBNs which are still playing out,” the statement says. “Downside risks in the near term could travel through two major channels: (a) short-run disruptions in economic activity in cash-intensive sectors such as retail trade, hotels & restaurants and transportation, and in the unorganised sector; (b) aggregate demand compression associated with adverse wealth effects,” the MPC explains. However, it adds that, “The impact of the first channel should, however, ebb with the progressive increase in the circulation of new currency notes and greater usage of non-cash based payment instruments in the economy, while the impact of the second channel is likely to be limited.”