RBI surprised many in the markets, but not us, by deciding to keep its key policy rate unchanged. Increased global uncertainty was cited as a key factor alongside concerns over the stickiness of both food and core inflation gauges. On the key issue of demonetisation, RBI sensibly sees this as essentially a transient, ephemeral shock that does not warrant a formal policy response. Obviously, if demonetisation proves to have a more lasting, pernicious impact on economic growth, RBI can respond with easier policy at a later date. Liquidity conditions are also expected to normalise quickly. The incremental CRR increase is confirmed as expiring this week with liquidity management reverting to the more orthodox use of reverse repo and MSS bonds. Assuming the demonetisation shock fades quickly, we continue to expect that the rate-cutting cycle is now over with inflation set to climb in 2017.
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RBI left its key policy rate the repo rate — unchanged at 6.25% following its final Policy Review of the year. The decision was largely unexpected although we were in a very small minority expecting unchanged policy rates. Three factors appear to have been key. First, the MPC is clearly cognisant of increased global uncertainty. ‘Imminent tightening’ by the US Federal Reserve, the risk of ‘spill-overs’ to emerging markets and ‘firmer oil prices’ were all cited as reasons for caution. Second, the stickiness of inflation, particularly ‘core’ inflation, was noted as ‘disconcerting’ and potentially generating a resistance level for future downward movements in inflation. In line with our forecasts, RBI acknowledged that inflation risks are skewed to the upside even before the full impact of the 7th Pay Commission on housing costs, let alone the impact of the goods and services tax, has been factored in. On the critical issue of ‘demonetisation’, RBI sensibly viewed it as a largely ‘transient’ shock that, in the base case, does not warrant a formal policy response.
Chief economist, Emerging Markets, BNP Paribas