Rate cut signals growth concerns but limited policy space

Published: October 5, 2019 2:44:35 AM

The statement states that “with inflation expected to remain below target in the remaining period... there is policy space to address these growth concerns by reinvigorating domestic demand.”

Monetary Policy Committee, Rate cut, Reserve Bank of India, MPC, CPI inflation projection, GDP growth, FY20 growth forecast projectionThe RBI raised its Q2 FY20 CPI inflation projection to 3.4% in from 3.1%.

By Sonal Varma & Aurodeep Nandi

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) voted 5-1 in favour of reducing the policy rate by 25bp to 5.00%, in line with consensus, but less than our expectation of 35-40bp. Dr Dholakia, who voted for a 40bp cut, was the only dissenter. The MPC maintained its “accommodative” policy stance, implying the next policy action is either a hold or a cut.

The statement states that “with inflation expected to remain below target in the remaining period… there is policy space to address these growth concerns by reinvigorating domestic demand.” As expected, the RBI reduced its GDP growth projection for FY20 (year-ending March 2020) to 6.1% y-o-y from 6.9% (with downside risks), in light of the disappointing Q1 FY20 print. The RBI now projects growth of 5.3% in Q2 FY20 (6.6% previously), while its H2 FY20 projection was lowered to 6.6-7.2% (from 7.3-7.5%), with risks “evenly balanced”. GDP growth for Q1 FY21 was also revised down to 7.2% from 7.4%.

The RBI raised its Q2 FY20 CPI inflation projection to 3.4% in from 3.1%. However, it retained its 3.5-3.7%
projection for H2 FY20 and its 3.6% projection for Q1 FY21 (Q2 CY20). As such, the RBI sees inflation remaining within its 4% target.

The October policy meeting was set against a backdrop of weaker growth, a resurgence of financial stability risks and a surprise fiscal stimulus (corporate tax cut). In the event, the RBI’s decision to deliver a more benign 25bp rate cut suggests it is trying to balance growth concerns against limited remaining monetary policy space and a diminishing efficacy of monetary policy in boosting growth (hence the growing role of fiscal policy).

Considering the weaker-than-expected growth outlook, we believe a front-loaded policy action would have been the right approach, as it would have enabled banks to sharply lower their lending rates ahead of the upcoming festive season.

While we are broadly in agreement with the RBI’s inflation trajectory, we believe the lowered FY20 growth projection is still optimistic. High frequency indicators suggest that growth is likely to slow further in Q3, after hitting 5% in Q2. Therefore, we see downside risks to our FY20 growth forecast of 6%, although we do expect the growth rate cycle to improve due to the lagged effects of easier monetary policy.

On policy, the RBI’s growth projection is set to be disappointed again at end-November (when Q3 GDP data are out), which keeps the door open to another cut at the December policy meeting. However, with the RBI having already delivered 135bp rate cut and diminishing marginal returns from each additional rate cut, we believe the rate easing cycle is closer to its end. We expect the RBI to deliver a final 15bps cut in December.

(Writers are research analysts at Nomura)

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