Monetary Policy: MPC Surprises With Status Quo On Rates Despite Growth Slump

India’s Monetary Policy Committee decided to keep interest rates unchanged, pausing a rate cutting cycle that began in February. The committee, however, said that its monetary policy stance remains “accommodative as long as it is necessary to revive growth while ensuring that inflation remains within the target”.

The committee cut its growth forecast for FY20 to 5 percent from 6.1 percent and raised its inflation forecast for the second half of the year to 4.7-5.1 percent.

Key Highlights

• MPC keeps repo rate unchanged at 5.15 percent.
• MPC keeps reverse repo rate unchanged at 4.9 percent.
• MPC maintains monetary policy stance at “accomodative as long as it is necessary”.
• MPC recognises that there is monetary policy space for future action.
• MPC votes 6-0 in favour of a status quo on rates.
• RBI cuts growth forecast to 5 percent in FY20 and 5.9-6.3 percent in first half of FY21.
• RBI raises inflation forecast for second half of FY20 to 4.7-5.1 percent.

Watch: MPC opts for a pause, cuts growth forecast

Concluding its three-day meet, the committee voted to keep the repo rate unchanged at 5.15 percent. The committee has pared rates by 135 basis points in the current cycle.

The decision was contrary to market expectation. All 34 economists surveyed by Bloomberg as of Wednesday forecast a reduction, with the majority expecting a quarter-point cut, and the rest pegging reductions at between 15 basis points and 50 basis points.

In explaining its decision, the committee said that it notes that economic activity has weakened further and the output gap, which is the difference between actual output and potential output, remains negative. However, it went on to add that several measures already taken by the committee and the government are expected to feed into the real economy.

The committee, instead, chose to focus on the recent rise in inflation. While inflation is expected to moderate to below the target by the second quarter of next year, the committee thought it prudent to monitor incoming data.

The door for further rate cuts remains open but remains data dependent.

The decision left several economy watchers perplexed, especially due to the sharp reduction in the growth forecast for the year.

“This is the worst-case scenario I would have painted for RBI to muddy the waters by bringing in inflation concerns,” said Abheek Barua, chief economist at HDFC Bank.

That the decision was a consensus view among all six members of the MPC also surprised commentators. “I would have ordinarily expected a bit of a non-consensus view even if RBI had chosen to hold this policy. But, the fact that it is a consensus view from all MPC members does indicate that clearly the priorities have changed and headline inflation again comes back into focus,” said Amandeep Chopra, head of fixed income at UTI AMC.

‘Temporary Pause’

But RBI Governor Shaktikanta Das reiterated that inflation targeting is the prime objective of the MPC, while explaining the decision to hold rates even as the RBI cut its GDP growth target sharply for FY20.

He also said, in a press briefing after the MPC statement, that the pause on rates is “temporary”.

• Calculation shows that during Q4 food inflation is likely to remain very high. Increase in telecom tariffs could have some impact on core inflation.
• Government has taken number of steps in four-five months like corporate tax rate cut, measures to improve auto sector demand and last-mile funding in real estate sector.
• RBI has reduced rates consistently since February. Liquidity has been in surplus mode since June.

• Effect of past policies is still playing out; should allow some more time for further reduction in lending rates.
• Would like to have to have greater clarity on kind of counter-cyclical fiscal measures to be announced in Budget 2020.
• Timing of rate cut important to ensure greatest impact.
• “We don’t want to be mechanical in cutting rates.”

Growth Outlook

GDP growth has fallen from 8 percent to 4.5 percent in a matter of five quarters. Both consumption and private investment have weakened, leaving government spending as the only support for the economy.

The MPC noted that growth has been weighed down by a sharp slowdown in investment and cushioned by government spending. Seasonally adjusted capacity utilisation has fallen to 69.8 percent in Q2 FY20 compared to 74.6 percent last year.

Services sector indicators, too, have weakened. Consumer are spending less on non-essential items.

“On the positive side, however, monetary policy easing since February 2019 and measures initiated by the government over the last few months are expected to revive sentiment and spur domestic demand,” the committee said.

The committee went on to add that RBI’s Industrial Outlook Survey indicates a marginal pick-up in business sentiment.

Inflation Outlook

Despite the weakened growth outlook, the committee, with a flexible inflation targeting mandate, decided to focus on signs of rising inflation. It chose to stick to the legal mandate of targeting headline inflation, even though demand-driven core inflation has plummeted in recent months.

The projection for headline CPI has been revised upwards to 4.7-5.1 percent in the second half of the year compared to 3.5-3.7 percent earlier. For the first half of next financial year, the committee pegs inflation at 3.8-4 percent.

The inflation outlook is likely to be influenced by several factors, the committee said:

• First, the upsurge in prices of vegetables is likely to continue in immediate months.
• Second, incipient price pressures seen in other food items such as milk, pulses, and sugar are likely to be sustained.

• Third, both the 3-month and 1-year ahead inflation expectations have risen sharply.

Monetary Transmission

Commenting on transmission of monetary policy, the MPC said that pass through of rate cuts to the money markets has been complete.

Since introduction of external benchmarking, most banks have linked lending rates to the repo rate and deposit rates have fallen. This, the MPC believes, will lead to improved transmission of rate cuts to the banking system as well.

Market Reaction

As the MPC decision came in contrary to expectations, both equity and bond markets sold off. The benchmark equity index Nifty 50 and Sensex slipped into losses from gains of a quarter of a percentage, later flattening out. But the Nifty Bank Index remained in losses, down 0.35 percent.

The 10-year government yield spiked to 6.56 percent, about 6-7 basis points higher than earlier in the day. The rupee weakened to 71.58 versus 71.48 to the dollar.