As expected, the Monetary Policy Committee (MPC) left the repo rate and the monetary policy stance unchanged at 6.5% and calibrated tightening, respectively, in the December 2018 policy review, with food and core CPI inflation displaying contrasting trends, and uncertainty related to major components of the inflation outlook. While the vote on the repo rate was unanimous, there was one dissent in favour of changing the stance back to neutral.

Following the sharp sequential dip in GDP growth in Q2FY2019, we had expected the MPC to cut its growth forecast for the current fiscal. However, the committee left its growth forecast for FY2019 unchanged at 7.4%, and placed its forecast for H1 FY2020 at a healthy 7.5% with risks tilted to the downside. In particular, with capacity utilisation rising to a seasonally adjusted 76.4% in Q2FY2019, the MPC remarked that the output gap remains virtually closed, which is an encouraging sign for further capacity expansion.

As anticipated, the MPC revised its inflation projections downwards, forecasting the same at 2.7-3.2% in H2FY2019 and 3.8-4.2% in H1FY2020, with risks tilted to the upside. A great deal of emphasis was placed on the extent of uncertainty towards inflation risks related to factors such as prices of food and fuels, and the potential impact of volatile global financial markets and domestic fiscal slippages, particularly given the elevated level of the core CPI inflation.

Going forward, geopolitical developments and supply-demand balances would continue to affect crude oil prices, the sentiment toward the rupee, and the inflation outlook. Our base case does not factor in a sharp rebound in crude oil prices or a re-testing of the all-time low by the rupee.

However, the outlook for food inflation remains mixed, with lagging rabi sowing and the potential impact of revised minimum support prices for various crops on market prices, casting some doubt on how long food prices would remain in the disinflation zone.

The extent of the variability in the individual MPC members’ inflation outlook may be clarified in the upcoming minutes, which will be keenly dissected. At present, there appears to be a substantial likelihood of a change in the monetary policy stance back to neutral from calibrated tightening in the February 2019 policy review, as a precursor to a repo rate cut in Q1 FY2019, if the feared inflationary pressures do not materialise.

As expected, the central bank did not cut the cash reserve ratio to ease liquidity conditions, having already conducted substantial open market operations (OMOs) to purchase government of India securities (G-sec) of 1.36 trillion in April-November 2018, and having announced a pipeline of further OMOs of 40,000 crore for December. In our view, the Reserve Bank of India is likely to continue addressing structural liquidity mismatches through OMOs and frictional liquidity mismatches through term repos with variable tenors in Q4 FY2019, rather than cutting the CRR in the near term.

The yield on the benchmark 10-year G-sec eased appreciably to around 7.44% after the announcement of continued OMOs to inject liquidity, amid the sharp reduction in the MPC’s inflation forecasts, which would complement the impact of the recent decline in the US 10-year yield and some stabilization in crude oil prices at a relatively moderate level. Based on such factors, we expect the 10-year G-sec yield to trade in a band of 7.3-7.7% in the remainder of this quarter. An upward revision in the government’s borrowing calendar for Q4 FY2019 is the key risk that could significantly push up G-sec yields from the current levels.

Aditi Nayar is principal economist at Icra Ltd.

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