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Repo Rate Unchanged: 6.5%, Policy Tone Unchanged at “Calibrated Tightening”

Dec 5, 2018

The Reserve Bank of India today decided to maintain the policy repo rate at 6.5% unanimously. The MPC maintained its stance at “calibrated tightening” on monetary policy and commitment to achieving a medium-term target for CPI of 4% ± 2%, while supporting growth.

Key highlights of the RBI’s Monetary Policy
Global Macro Weakening

Global economic activity has shown increasing signs of weakness on rising trade tensions. Among advanced economies, economic activity appears to be slowing in the US. The Euro area growth has also lost pace in Q3, impacted by weaker trade growth. The Japanese economy contracted in Q3 on subdued external and domestic demand. Economic activity also decelerated in major emerging market economies in Q3. In China, growth slowed down on weak domestic demand. The ongoing trade tensions and the possible cooling of the housing market pose major risks to growth in China. The Russian economy has lost some traction as well, pulled down largely by a weak agricultural harvest.

Domestic Macro Indicators Mixed Bag

Gross domestic product (GDP) growth slowed down to 7.1 per cent YoY in Q2FY19, after four consecutive quarters of acceleration as compared to 8.2% in Q1FY19 (a 9 quarter high), weighed down by moderation in private consumption and a large drag from net exports. Private consumption has slowed down possibly on account of moderation in rural demand, subdued growth in kharif output, depressed prices of agricultural commodities and sluggish growth in rural wages. However, growth in government final consumption expenditure (GFCE) has strengthened, buoyed by higher spending by the central government. Imports growth accelerated at a much faster pace than exports, resulting in net exports pulling down aggregate demand. Capacity utilisation has increased from 73.8% in Q1 to 76.1% in Q2, which was higher than the long-term average of 74.9%; seasonally adjusted CU also increased to 76.4 per cent. Further, PMI remains in expansion zone, well above 50.

Significant Fall in Inflation

Retail inflation has fallen from 4.9% in Jun-18 to 3.3% in Oct-18, dragged down by food inflation. CPI inflation ex food and fuel accelerated to 6.1 per cent in October. A large fall in food prices has pushed the food group into deflation and more than offset the increase in inflation in items excluding food and fuel. Inflation expectations of households, measured by the November 2018 round of the Reserve Bank’s survey, softened by 40 basis points for the three-month ahead horizon over the last round reflecting decline in food and petroleum product prices, while they remained unchanged for the twelve-month ahead horizon.

Market Reaction

  • Yield on the 10 year Government bond is down to 7.47% (down 10 bps intraday) on the back of a significant fall in expected inflation rates, crude and expectation of a rate cut as RBI’s next action. Yields have come off significantly from 8.18% levels in September.
  • USDINR is trading at 70.60 levels up 10 paise from previous days levels of 70.50.

The MPC guided for a significant fall in headline inflation (incl. HRA):

Outlook

  • 2.7-3.2% for H2FY19 (vs. 3.9-4.5% earlier)
  • 3.8-4.2% for H1FY20 (vs. 4.8% for Q1FY20)

Even as inflation projections have been revised downwards significantly and some of the risks pointed out in the last resolution have been mitigated, especially of crude oil prices, several uncertainties still cloud the inflation outlook.

Firstly, the prices of several food items are at unusually low levels and there is a risk of sudden reversal especially of volatile perishable items. Also, uncertainty continues about the exact impact of MSP on inflation, going forward. The medium-term outlook for crude oil prices remains uncertain due to global demand conditions, geo-political tensions and decision of OPEC which could impinge on supplies. Households’ one-year ahead inflation expectations remain elevated and unchanged. Risks of fiscal slippage exist at the Centre and/or States.

The GDP growth rates expectations have broadly been maintained at similar levels as in the previous policy. The MPC expects:

  • 7.2-7.3% for H2FY19 (vs. 7.1-7.3% earlier)
  • 7.5% for H1FY20 (vs. 7.4% for Q1FY20 earlier)

Notably, the gap between the g-sec 10 year and repo rate has contracted significantly. Globally, the much awaited inversion in the U.S. yield curve came to pass on some pairs, accompanied by a sharp fall in markets overnight. From a macro perspective, the 50 bps decline in domestic yields is a positive, as is low inflation and lower crude oil prices. Markets remain concerned about geo-political tensions and the continuation of the trade war. Domestically, elections pose another uncertainty. In the short term these uncertainties are likely to weigh on markets. In the longer term, the fundamental picture on the domestic front remains generally benign.

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