The monetary policy committee’s (MPC) move to keep the repo rate unchanged at 5.15% was prompted by the recent spike in consumer price index (CPI) inflation—which is expected to intensify over the next two months—as well as the delayed and incomplete transmission of the 135-basis point rate cuts already effected over February-October, despite which economic growth remains tepid.

With CPI inflation rising sharply in October, led by the transient surge in vegetable prices, and relatively more durable risks arising from firming prices of milk, pulses and sugar, as well as the hardening of inflation expectations of households, the MPC sharply revised its CPI inflation forecast for H2 FY20 to 5.1-4.7% from 3.5-3.7%, with risks broadly balanced. This is well above the mid-point of the committee’s medium-term target of 4%+/-2%—justifying the pause in Thursday’s policy review. Moreover, the estimates for H1 FY21 have been placed at 4-3.8%, with risks broadly balanced, in place of the October forecast of 3.6% for Q1 FY21, with risks evenly balanced. A catch-up in rabi sowing, abundant precipitation and healthy reservoir levels should ideally ease food price pressures going ahead. Moreover, slowing domestic demand and range-bound crude oil prices should limit inflationary risks in non-food items.

Accordingly, the MPC expects CPI inflation to ease in H1 FY21 from the level projected for H2 FY20, although the trajectory is now higher than the earlier forecast. In addition, the MPC’s projection for economic growth in FY20 has undergone another sharp cut. It has now been placed at a muted 5% in the December policy review, down from the October forecast of 6.1% with risks evenly balanced, and the sanguine August 2019 projection of 6.9%, albeit with risks to the downside.

Moreover, the growth forecast for H1 FY21 has been pegged at a moderate 5.9-6.3%, in place of the October projection of a 7.2% expansion in Q1 FY21. While the GDP growth stood at 4.8% in H1 FY20, dampened by weak investment impulses, the MPC remarked that there were early signs of a recovery in investment activity. Despite this, it expects the pickup in GDP growth in H2 FY20 to be rather shallow, at 4.9-5.5%.

The MPC move came amid the lack of clarity on the evolving growth-inflation outlook, incomplete transmission of past monetary actions both to bank lending rates and interest rates of small savings schemes, and growth-supporting measures that may be introduced in the FY21 budget. However, it reiterated that the stance will remain accommodative for as long as necessary to revive growth, and explicitly stated that there was space for future monetary policy action. This has provided a strong signal that the MPC remains committed to boosting economic activity, if inflation allows it to do so.

In our assessment, the next two prints of CPI inflation are likely to be fairly unpleasant. While food inflation would flare up further in November and start to ease mildly in the ongoing month, the recently announced hike in telecom tariffs may push up core inflation in December. As a result, another pause in the February 2020 policy review now appears imminent.

In our view, while this may not be the end of the rate reduction cycle, the next repo rate cut will be forthcoming only after there is clarity on the headline CPI inflation sustainably easing below 4%.

Aditi Nayar is principal economist at Icra.

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