Tone of policy less hawkish than feared
The last planned review of the monetary policy committee (MPC) for FY2018 did not offer many surprises. In line with our expectations, it left the repo rate unchanged at 6%, retained the neutral stance of monetary policy and reiterated the commitment toward achieving the medium-term inflation target of 4%.
As anticipated, the decision to keep the repo rate unchanged was not unanimous, with one MPC member voting for a hike of 25 basis points (bps). Additionally, the inflation forecast for Q4 FY2018 was revised upward, while the baseline expectation for GVA growth for FY2018 was pared mildly.
However, the tone of the policy outlook was less hawkish than what the markets had started to fear. The caution regarding the need for vigilance around the evolving inflation scenario clouded by upside risks was counterbalanced by the emphasis on nurturing the nascent recovery through conducive and stable macro-financial management.
To recap, the CPI inflation spiked to 5.2% in December 2017, overshooting MPC’s earlier forecast. In maintaining status quo, MPC appears to have looked through the impact of the revision in house rent allowance (HRA) for central government employees on the uptick in the CPI inflation. Moreover, the presence of mitigants, such as subdued capacity utilization, moderate rural wage growth and the possibility of crude oil prices receding from current levels, supported MPC’s decision to maintain rates and persist with the neutral stance.
Nevertheless, the sixth bi-monthly policy statement highlighted various risks, including the first and second round impact of the staggered revision in HRA by state governments; the possibility that firms may pass on higher global commodity prices to consumers; and the proposals made in the Union budget for FY2019 to augment minimum support prices (MSP), increase customs duty on certain items, and delay fiscal consolidation. In particular, MPC commented that the fiscal slippage has started to raise economy-wide costs of borrowing, which may spark inflationary pressures going forward. Based on these risks, MPC revised its inflation estimate for Q4 FY2018 (including the HRA impact) to 5.1%, above its earlier forecast of 4.3-4.7% for H2 FY2018. Moreover, it expects CPI inflation to harden to 5.1-5.6% in H1 FY2019, followed by a moderation to 4.5-4.6% in H2 FY2019, albeit with risks tilted to the upside. The expected softening in inflation in H2 FY2019 is attributed a favourable base effect related to the waning impact of the HRA revision from July 2018 onwards, and the expectation that a normal monsoon and effective supply management would dampen food inflation. Overall, MPC emphasized caution about the evolving inflation scenario.
MPC mildly revised its baseline expectation for GVA growth for FY2018 to 6.6% from 6.7%. It pegged the GVA growth forecast for FY2019 at 7.2% with risks evenly balanced, with an anticipated easing from 7.3-7.4% in H1 FY2019 to 7.1-7.2% in H2 FY2019. It attributed the improvement in FY2019 GVA growth to factors such as the stabilization of the economy after the transition to GST; signs of a nascent investment revival provided by rising credit growth, equity fundraising, imports and capital goods production; the ongoing recapitalisation of public sector banks; and the prospect of rising exports on the back of an improving global economy. However, it warned of downside risks from the deterioration in public finances, which might crowd out private financing and investment.
Looking ahead, the emphasis placed by the committee on nurturing the fledgling recovery and on stability suggests that it would prefer to wait for additional data on the extent to which the upside risks to inflation materialize. Therefore, it is unlikely to hike rates in the immediate term, in our view. However, if CPI inflation exceeds MPC’s forecast in a sustained manner, a rate hike toward the second half of 2018 may not be ruled out.
The softer-than-expected tone of the policy document should help to contain yields of government securities (G-secs) to some extent, even though the prospects of open market operations being conducted by the central bank to purchase G-secs appear dim. Regardless, global trends related to liquidity, inflation and interest rates would continue to influence the direction of Indian bond yields in the near term.
Aditi Nayar is principal economist at Icra.
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