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Calibrated Tightening to a Repo Rate Cut, Policy Tone changed to “Neutral”

Feb 7, 2019

The Reserve Bank of India today decided to reduce the policy repo rate to 6.25% from 6.50% with four out of six members voting in favour of the cut. The MPC also decided to change the monetary policy stance from “calibrated tightening” to “neutral” with an objective of achieving a medium-term target for CPI of 4% within a band of ± 2%, while supporting growth.

Key highlights of the RBI’s Monetary Policy

The MPC guided for a significant fall in headline inflation:

• 2.8% for Q4FY19 (vs. expectation of 2.7-3.2% in H2FY19)

• 3.2-3.4% for H1FY20 (vs. 3.8-4.2% earlier)

• Guided for 3.9% in Q3FY20

The GDP growth rates expectations:

• 7.2 for FY19 (vs. 7.4% projected earlier)

• 7.2-7.4% for H1FY20 (vs 7.5% earlier)

• 7.5% in Q3FY20 and 7.4% for FY20

Rationale for a Rate Cut

In listing its rationale for a rate cut, the RBI flagged slowdowns in economic activity in the U.S., slowing global trade, and weak industrial activity in the Eurozone, as well growth slowdowns in major emerging market economies (EMEs). In China, growth decelerated in Q4CY18.

Domestically, the RBI highlighted high frequency indicators in the services sectors suggesting a moderation in the pace of activity. In addition, sales of motorcycles, tractors, commercial vehicles and passenger cars have contracted recently, possibly reflecting volatility in fuel prices.

Lead indicators for the hotels sub-segment, viz., foreign tourist arrivals and air passenger traffic, point to softening in November-December. In the communication sub-segment, the telephone subscriber base contracted in October-November, while that of broadband continued to expand in October. The services PMI continued to expand in January 2019 despite a dip from the previous month. Indicators of the construction sector, viz., consumption of steel and production of cement, continued to show healthy growth, though growth in cement production inched lower in November 2018, reflecting a base effect.

Further, the index of the industrial outlook survey (IOS) for Q3:2018-19 suggests a weakening of demand conditions in the manufacturing sector. Some indicators of investment demand, viz., production and imports of capital goods, contracted in November/December, and credit flows to industry remain muted.

A Calibrated Tightening to a Rate Cut

The predominant question market participants will be considering is why the rate cut when the MPC was in calibrated tightening mode.

Clearly, some will view the RBI as aligned with the government’s pro-growth agenda and why not. Since when do central banks have to be at loggerheads with the government.

Second, the RBI is justified in terms of the data – particularly its inflation targeting mandate – to come forward with a rate cut, with inflation at the low end of the 2% lower band. Third, there are clear domestic and international risks to the growth outlook, and a rate cut today that assists in improving sentiment, reduces cost of capital and spurs growth is a proactive rather than reactive move.

Outlook

A Rise in Vulnerability on the Fiscal Side?

The RBI highlighted that it had reviewed the projections on GST collections and costs of fiscal stimulus, and was comfortable with the projections, with review on a going forward basis.

Market Reaction

• Yields on the 10 year Government bond are down to 7.32% (down 3.6 bps intraday). Yields have come off significantly from 8.23% in September.

• USDINR is trading at 70.52 marginally up by 4 paise from previous close of 70.56.

With fiscal and monetary policy supportive, we expect an uptick in current quarter and future economic activity. Risks on the inflation front remain distant at this time, with crude obviously being a risk to the forecast.

Fiscal conservatives will clearly question the RBI’s pro-growth strategy. In the final analysis, given a choice between a pro-growth central bank and a hawkish fiscally conservative central bank, a pro-growth strategy is clearly preferable.

Some of us clearly remember the pain that was experienced by Latin American and South East Asian countries that had a cocktail of fiscal prudence thrust upon them. In a world awash with central bank liquidity, fiscal and monetary stimulus, particularly in a low inflation environment, is a move towards restoring domestic growth. While bond vigilantes will question the impact on the fiscal deficit, the government and the RBI clearly have a number of levers to work with and that’s what the bond market seems to be suggesting.

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