Stance shifted to ‘neutral’ from ‘calibrated tightening’, action dovish

New Delhi | Updated: February 8, 2019 4:27:26 AM

The central bank expects overall food inflation to remain benign in near term. While the annualised food inflation could remain benign in near term, the momentum could see a build-up in coming months.

RBI, Monetary Policy Committee, Shaktikanta Das, rbi policy rate, Inflation, oil prices

By Shubhada Rao & Vivek Kumar

Contrary to market expectation of a status quo, the Reserve Bank of India’s Monetary Policy Committee reduced its benchmark repo rate by 25 bps to 6.25 percent at its sixth bi-monthly policy review. As such, the reverse repo rate and the MSF rate now stand adjusted at 6.00%, and 6.50 percent respectively.

Four out of six MPC members voted for the rate cut, with the other two voting to keep the policy rate unchanged. The rate cut decision was accompanied by a shift in monetary policy stance to ‘neutral’ from ‘calibrated tightening’ earlier. This was not only on expected lines by market consensus, but also a unanimous thought process within the MPC.
Key takeaways

Inflation: The central bank lowered its CPI inflation trajectory to 2.8percent in Q4 FY19 and 3.2-3.4 percent in H1 FY20 vis-à-vis its earlier projection of 2.7-3.2percent in H2 FY19 and 3.8-4.2 percent in H1 FY20. It also introduced its CPI inflation forecast for Q3 FY20, which is pegged at 3.9 percent.

Growth: The central bank introduced its FY20 GDP growth forecast at 7.4percent (with risks evenly balanced), up from CSO’s estimate of 7.2 percent in FY19.

Rationale for forecasts: The downward revision to the CPI inflation trajectory primarily reflects the “unprecedented soft inflation recorded across food sub-groups”. This is along expected lines as India’s food inflation has been persistently surprising on the downside in recent quarters. In addition, crude oil price has been more or less stable while few items within domestic fuel have turned soft.

Our take
If one were to zoom out, it becomes evident that CPI inflation has been undershooting its mandated target on a trend basis. With average CPI inflation of 3.6percent in FY18, the implied average CPI inflation in FY19 comes around 3.5-3.6 percent. Further, for FY20, the implied forecast average CPI inflation currently tracks 3.6-3.8 percent (assuming a close to 4percent inflation outturn for Q4 FY20). If one were to zoom in, then what comes out is the observation that after remaining below the 4 percent target in Q2 and Q3 of FY19, the RBI projects headline inflation to remain sub 4 percent in each of the next four quarters, i.e. until Q3 FY20.

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With the governor reiterating the statutory mandate of targeting 4 percent inflation (with a band of +/- 2%), such a benign outcome along with the projected outlook indeed provided room for the central bank to eke out a dose of monetary accommodation. Factors like a sizeable correction in inflation expectation of households and producers, re-opening of the negative output gap (likely after the Q2 FY19 GDP data along with the outlook for H2 FY19), and relatively dovish commentary from the US Fed and the ECB further supported the decision to reverse the course of monetary policy.

Going forward, the future course of monetary policy trajectory would depend upon the following: The central bank expects overall food inflation to remain benign in near term. While the annualised food inflation could remain benign in near term, the momentum could see a build-up in coming months.

Oil price “outlook continues to be hazy”. We couldn’t agree more on this as crude oil price has seen heightened volatility in the last one year amid heavy geopolitical intervention. The futures market currently expects oil prices to end 2019 at an average price of $62.5, which is almost the same as the prevailing spot price. If oil price were to pan out along these lines, then there can be favourable impact on monthly FY20 inflation prints via statistical base effects.

The Budget has upped the share of revenue expenditure, which we reckon would help in boosting private consumption. While this could transpire into higher pressure on demand-led inflation, the impact is “likely to materialise over a period of time”. Keeping in mind the implementation lags and its trickle down effect, such an outcome is quite likely. However, we believe the central bank would need to be extremely vigilant in this case as few items within core inflation have already started exhibiting unusual upward price pressures.

Assuming the India crude basket to average close to $65 per barrel in FY20, we expect average CPI inflation to edge towards 4.1 percent in FY20 from an average of 3.7percent in FY19. This calls for a prolonged pause in monetary policy with the likelihood of a moderate improvement in GDP growth momentum in the backdrop of a consumption-led fiscal stimulus.

However, we note that forecasting domestic food and global crude oil prices is fraught with extreme challenges. If the recent softness in price of these commodities were to persist in the coming quarters, then there can be a likelihood of extending the sub 4 percent inflation trajectory beyond Q3 FY20. Such a scenario (which would be clearer with the next update of RBI’s bi-annual Monetary Policy Report) could then potentially open up space for incremental monetary accommodation, as early as in April 2019.

(Shubhada Rao is chief economist at Yes Bank and Vivek Kumar is senior economist at Yes Bank)

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