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MUMBAI : As surprises went, the monetary policy packed a punch this time. Not only was a rate cut rabbit pulled out of the hat, but it was also dressed up with the veiled promise of more cuts through a reduction in inflation forecasts.

What was even more surprising was that the hands holding the hat included long-standing hawk Michael Patra, in-charge of monetary policy at the Reserve Bank of India (RBI).

Gaurav Kapur, chief economist at IndusInd Bank Ltd, says, “While the change in the monetary policy committee’s (MPC’s) stance was along expected lines, the timing of the cut has come as a slight surprise. Note also that in the run-up to this meeting, the overnight index swaps market was pricing in only one rate cut within the next one year, keeping in mind the expansionary nature of the interim budget and high core inflation."

RBI’s rate-setting MPC voted 4:2 for a cut, with governor Shaktikanta Das decidedly in favour of one. If we look only at headline inflation, a rate cut was a no-brainer. It came in at merely 2.2% in December, something that a fastidious RBI should be alarmed about, since the risk of inflation breaching the lower 2% barrier was real.

That would mean a blotch on the central bank’s record of not keeping inflation at or above 2%, which is of course ironic for a country once threatened by high inflation. The MPC’s mandate is 2-6% inflation range, with 4% as the mid-point target to achieve on an enduring basis.

But what tilted the odds to the rate cut were inflationary expectations. Indians now expect inflation to be benign as the central bank’s survey of households revealed. Households’ expectations on inflation in the next three months have fallen by 80 basis points (bps) and for the next one year by 130 bps, said RBI. A basis point is 0.01%.

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(Sarvesh Kumar Sharma/Mint)

This is music to a central bank’s ears, siSarvesh Kumar Sharma/Mintnce monetary policy targets inflation expectations. The revision in the headline inflation forecast for the entire 2019 was a massive 60 bps, with RBI’s models forecasting that inflation would be at best 3.9% by the end of this year. That suggests a 4% target is already a checked box and RBI can afford to bring down cost of borrowing for individuals and companies.

“Now that the MPC has advanced the rate cut, the chances of another cut soon have increased; of course subject to the incoming prints of consumer price inflation, which will be a key factor to watch," adds IndusInd Bank’s Kapur.

But in the process, there were two things RBI chose to not dwell upon—fiscal slippage and core inflation.

RBI has chosen to stick with its mandated headline inflation and not really fret about core inflation, which has been stubborn, and has a number of analysts worried. To its credit, RBI’s statement alluded to the need for close monitoring of core inflation.

On the fiscal situation, Das has chosen to take the budgeted numbers on face value. Most in the market are sceptical about the government’s math, and were discomfited by the governor’s unsatisfactory answer to questions about the fiscal situation. That explains why bond traders took the rate cut and accompanying statement mildly as yields fell initially, but rose back up during the day.

While brushing aside these concerns, Das has shifted the focus to growth, a marked shift for the central bank. He pointed out in a press conference that since price stability has been met, RBI should be friendlier to growth, especially with the output gap demanding attention.

But this does not sit very well, because why cut rates when there are no apparent worries about growth?

RBI lowered its growth forecast for FY20 by just a shade. Its own surveys don’t point to a big trouble with growth, as the business expectations index show an improvement. Even the order books, inventory and capacity utilization survey points to a rise in capacity utilization, albeit by a small margin.

The central bank said there is an output gap that has emerged which needs to be addressed. Perhaps, what it is also worried about is the expected fall in public capital expenditure next year, as shown by the budgeted numbers. If private investment remains lacklustre, too, revival of investment will only get more postponed. The economy can ill afford such a delay when it is finding its feet on recovery.

Of course, monetary transmission takes a long time to translate into increased demand and investment. But perhaps, RBI’s gambit of getting accommodative, at the same time when the government is putting money in the hands of consumers, will result in higher growth. The big risk of course will be whether its own subdued inflation targets will also stand.

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