The Monetary Policy Committee’s unanimous decision to hold the repo rate steady at 5.15% in the December policy meeting took the entire market by surprise, especially as the statement noted that economic activity has weakened further and the output gap remains negative. The decision was likely informed by several reasons, listed below:
*An upward revision to CPI estimate. CPI projection was revised up to 5.1-4.7% range for 2HFY20 (from 3.5-3.7% earlier) and to 4-3.8% range for 1HFY21 (from 3.6% in April-June’20 earlier).
*To wait for complete transmission of the previous rate cut to the weighted average lending rate (WALR). Relative to the 25 bps repo rate cut delivered in early October, the incremental reduction in WALR has only been 15 bps.
*To wait for more information regarding possible counter-cyclical fiscal measures to be announced in next year’s budget.
*To break the dependence of market in expecting a rate cut in every monetary policy on a mechanical basis.
*To implicitly indicate that there could be more announcements (such as “operation twist", outright OMO purchases or some form of troubled asset relief programme, or TARP) outside the RBI policy, which could aid transmission and economic recovery.
Despite the surprise move, we continue to expect further easing in 2020. RBI has revised its growth forecast downward by 110bps for FY20 to 5% (Deutsche Bank’s estimate is also 5%). The central bank has also clearly stated that there is space for additional easing and the current decision should therefore be interpreted as a “temporary pause".
As per our inflation estimate, we expect CPI to ease toward the 4% target in Q2’20, driven by reversal in vegetable prices over the next few months. Our CPI forecast for the next 12 months is about 4%, while our growth forecast for the next four quarters is about 5.8%. Applying a simple Taylor Rule formula, this implies a terminal repo rate of 4.5%, which we are projecting at this moment.
As far as suggestions regarding “operation twist" and OMO purchases for yield management are concerned, we are not sure whether RBI will like to get directly involved, especially with the recent report on liquidity framework suggesting that the central bank remains cautious about using excessive OMOs, as it can distort the yield curve. If achieving greater transmission is the main objective, then a better way is to aim for a larger dose of repo rate cut. It is with this view, that we have a target of 4.5% terminal repo rate (which can be higher if RBI decides to opt for other unconventional measures).
And as for sequencing of the repo rate cut, February remains a close call. If CPI inflation peaks in November (DB estimate 5.3%) and starts reversing swiftly thereafter, then there is still a case for a rate cut in February. Otherwise, the next 25 bps cut will likely be pushed to April. Next year’s budget, the evolving growth dynamic, and incremental transmission in the next few months will also inform the MPC’s decision about the “right timing" for the next cut. As of now, we are projecting a 25 bps cut in February, followed by another 25 bps and 15 bps reduction in Q2’20 and Q3’20 respectively.
Kaushik Das is chief India economist at Deutsche Bank