The MPC in the last two policy reviews had shown increasing concerns on growth.
By Shubhada Rao & Vivek Kumar
The monetary policy under the MPC formulation has not been bereft of surprises. The December 2019 policy review also posted one — with RBI’s MPC delivering a status quo vis-à-vis consensus expectation of a rate cut. However, the surprise in this policy review stands apart. All six MPC members voted unanimously to keep repo rate unchanged at 5.15%. This is in stark contrast to the interest rate cut expectation of 15-50 bps observed in the Bloomberg poll of 43 economists/analysts. Clearly, the entire market was leaning on one side (notwithstanding the difference in the individual slope) whereas the entire MPC turned out to be unwavering. In other words, the policymakers had a unanimously different take on the interest rate outcome vis-à-vis the unanimous expectation of market participants!
So, what led to this stark divergence? Why did the market position itself ahead of the curve? To get a perspective, we need to take a couple of steps back. The MPC in the last two policy reviews had shown increasing concerns on growth. While the August 2019 review saw administration of a higher and unconventional dose of monetary easing (35 bps cut instead of an expectation of a 25 bps multiple move), the October 2019 one saw a bold forward guidance continuing with the “accommodative stance as long as it is necessary to revive growth”, besides the expected delivery of a 25 bps cut in the repo rate. With incremental information on growth turning dire (Q2FY20 GDP growth plummeted to a 26-quarter low of 4.5% y-o-y), it was natural for market expectations to lean (in unison) on the side of accommodation for the December 2019 policy review. But status quo in December 2019 policy review reveals a few observations that may have got overlooked by market participants.
The MPC has never cut repo rate with the most recent CPI inflation overshooting the target. Recall that the October 2019 print for CPI came at 4.62%. That’s a 62 bps positive deviation from the target, and the largest in the past 16 months (with the previous 15 months witnessing negative deviations).
The transient food inflation spike is appearing to develop a fatter tail than initially anticipated. While the problem of delayed supply response could see resolution from incoming kharif produce along with administrative steps taken by the government by February 2020, upside food price pressures are getting broadbased with cereals, pulses, milk, and sugar showing signs of hardening, besides vegetables (especially onions), which is at present the culprit.
The recent hike in telecom tariffs by all the major players is likely to impart 40 bps upside to inflation. This will pull average FY20 inflation up by 10 bps, while the remaining 30 bps will manifest in the average FY21 inflation. Taking these into account, there is likelihood of CPI inflation remaining above 5% in Q4FY20. While it is likely to moderate thereafter, we expect it to remain above 4.5% in H1FY21.
While the markets focused on the bold October 2019 guidance of maintaining accommodative policy stance as long as it is necessary, the accompanying statement of “while ensuring that inflation remains within the target” seems to have got ignored. The December 2019 policy review reinforces the policy mandate of inflation targeting in an unambiguous manner.
Does this mean that the MPC has turned hawkish, or growth concerns have got abandoned? Far from it. The monetary policy stance continues to remain accommodative. However, amid a rising inflation trajectory, it would be challenging for the policymakers to cut interest rates. Since the MPC is close to the end of the current easing cycle, it would prefer to get clarity on the inflation and fiscal trajectory before using its interest rate ammunition. Any downward surprise in inflation or a favourable fiscal outturn could prompt incremental easing, albeit limited in magnitude. Meanwhile, easy liquidity conditions, introduction of external benchmarks for loan pricing, coupled with the cumulative 135 bps rate cut by RBI since February 2019 should enable the banking system to improve monetary policy transmission in the coming months. The MPC also hopes of policy complementarity from the government in the form of (i) providing greater flexibility to adjustments in small savings interest rates, and (ii) taking pro-growth steps (in the upcoming Union Budget besides the ones recently announced).
Overall, it appears the MPC is keeping an eye on inflation risks while focusing on extracting a bang for its buck (ie, monetary policy transmission) and rightfully emphasising on the need for supply side measures (ie, fiscal intervention). Last but not the least, the MPC also needs to keep its powder dry in a highly uncertain global environment. The writers are chief economist and senior economist, Yes Bank, respectively