The monetary policy committee (MPC) delivered another status quo on rates, following a similar action in its December 2016 meeting. The decision to leave rates unchanged was once again unanimous. And, in an important development, the MPC changed its stance to “neutral" from “accommodative", signalling that current rate cut cycle, which has seen cuts adding up to 1.75% since early 2015, has run its course for now.
While this move was not entirely unanticipated, the element of surprise is in the change in stance. The MPC remains in a conservative “wait and watch" mode as it awaits the resolution of uncertainty around the impact of demonetisation on growth and inflation. For instance, the Central Statistics Office’s assessment of GDP for 2016-17 is based on data for the first seven months, and therefore does not fully capture the impact of demonetisation on growth. Similarly, as the Reserve Bank of India (RBI) governor pointed out in the post policy press conference, the latest reading of CPI inflation for December of 3.4% would have been higher by 1.4%, if perishables like vegetables were excluded.
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The MPC while keeping rates unchanged used this announcement to reiterate its main objective of curbing CPI inflation durably to its medium-term target level of 4%. And here, the policy statement has re-emphasized the concerns about sticky core inflation and its broad-based nature. The change in stance can also be seen as an acknowledgement of the fact that reducing inflation to 4% on a sustainable basis is going to be more challenging than the reduction seen from levels of 6-6.5% over the last couple of years.
On the path of inflation in the coming fiscal year, the outlook is for headline CPI to inch upwards in the second half in the range of 4.5-5% as growth picks up, from 4-4.5% in the first. While the risks to this forecast path are balanced evenly, the MPC has highlighted three key upside pressures—hardening oil prices, pressure on the rupee on account of gradual normalization of US Fed rates and the impending implementation of the HRA (house rent allowance) adjustment from the Seventh Pay Commission.
In light of these upside risks, an indication about what level of inflation the MPC would be looking at as its intermediate target for March 2018 would have been helpful in understanding the room available for any further easing, if at all. The underlying rule which the RBI has been following is that real repo rate should be in the range of 1.25%-1.75%, the perceived natural rate for the economy. At the current juncture, even with the possibility of inflation dipping below 4% in the first half of the next fiscal, helped by a high statistical base effect, the MPC would be inclined to keep rates unchanged, unless these risks resolve favourably and monsoon is normal.
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The statement draws attention once again to high core inflation being an impediment to achieving the medium-term inflation target of 4%. While commending fiscal prudence on part of the government, the MPC continues to focus on structural challenges around the supply side of the economy, especially in the infrastructure sector.
The assessment on growth is largely in line with its past assessment, with a gradual recovery seen over the coming fiscal year to a rate of 7.4% from 6.9% this fiscal. The ongoing remonetisation and the resultant recovery in demand, especially in cash-intensive sectors, lower lending rates and higher capital spending by the government, are seen driving growth up. A decision to remove cash withdrawal restrictions on savings accounts by 13 March has also been made. This should facilitate a recovery in final demand and in economic activity in the next fiscal year.
The MPC statement also points out that the monetary transmission mechanism will improve with speedy resolution of bank NPAs, re-capitalization of public sector banks in order to restore their ability to lend and by moving to formula-based pricing of small savings instruments. In the meantime, the MPC has drawn comfort from the fact the demonetisation has hastened the monetary transmission of past cuts, as bank MCLRs have come down sharply since 8 November.
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The MPC is now likely to maintain status quo in the April meeting too, though it may have some headroom in the June policy, provided monsoon rains are normal. The rate cut cycle, which was anyway in its last leg, may have come to an end for now. Key risks to inflation emanating from upward pressure on oil and base metal prices and downward pressure on the rupee may not resolve in the direction which will significantly allay these concerns, ahead of the April meeting. That combined with uncertainty about the monsoon and food prices, especially post remonetisation may once again lead to the MPC holding firm on rates in April.
Gaurav Kapur is chief economist of IndusInd Bank Ltd. The views expressed are personal.