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Dismissing Risks From Demonetisation, Monetary Policy Committee Keeps Hawk Eye On Inflation

RBI officials on the monetary policy committee reaffirmed their commitment to bringing down inflation to 4 percent



Urjit Patel, governor of the Reserve Bank of India (RBI), centre, speaks during a news conference in Mumbai (Photographer: Dhiraj Singh/Bloomberg)
Urjit Patel, governor of the Reserve Bank of India (RBI), centre, speaks during a news conference in Mumbai (Photographer: Dhiraj Singh/Bloomberg)

Members of the Monetary Policy Committee (MPC) all felt that the impact of the government’s decision to withdraw Rs 500 and Rs 1000 notes from the system would be transitory.

While the committee acknowledged the uncertainty in near term economic outlook due to the demonetisation, all members seemed to be of the view that there would be little or no long term impact on the demand fundamentals of the Indian economy. As such, the committee felt comfortable in staying focused on its prime mandate of inflation control and reaffirmed its commitment to bringing inflation down to 4 percent over the medium term.

On December 7, the MPC surprised the markets by keeping rates unchanged contrary to the expectation of atleast a 25 basis point (bps) cut in rates. In its resolution, the committee said that it was prudent to wait and watch for a number of domestic and international factors to play out before taking a call on further interest rate cuts.

The minutes show that RBI governor Urjit Patel was of the view that inflation expectations still remain elevated, even though the credibility of the disinflation process has helped bring them down.

Correcting a misconception that had crept into the market after the October policy, Patel also clearly stated that the RBI intends to bring inflation down to the 4 percent mid-point of the flexible inflation target. Following the October policy review, analysts had noted that unlike predecessor Raghuram Rajan, Patel may be willing to allow inflation to remain in the band of 4 percent (+/-2 percent) rather than target the mid-point of that band. His comments now suggest otherwise.

Dismissing Risks From Demonetisation, Monetary Policy Committee Keeps Hawk Eye On Inflation

Patel’s view on the transitory impact of demonetisation was shared by deputy governor R Gandhi and executive director Michael Patra. Both did not see any significant long term downside from the withdrawal of bank notes which led to 86 percent of all currency being invalidated.

Since November 10, the RBI has supplied Rs 5.9 lakh crore in valid bank notes, it said in a separate statement on Wednesday. This is a little more than a third of the Rs 15 lakh crore that was scrapped.

There is uncertainty about the short-term impact of the decision to withdraw the legal tender status of Rs 500 and Rs 1000 denomination bank notes on the macroeconomy, although the impact is likely to be transitory. I, however, don’t see any significant downside risks to the medium-term growth prospects of the economy. 
R Gandhi, Deputy Governor, Reserve Bank of India

Patra also highlighted global uncertainties and said that developments taking place overseas may have a longer lasting impact than domestic disruptions.

While domestic supply disruptions and demand compression appear to be transient, global developments, including the morphing of political changes into macroeconomic risks, could likely be longer-lived and more challenging. Under these conditions, precaution warrants careful monitoring of the manner in which these forces play out and influence the near- to medium-term.
Michael Patra, Executive Director, Reserve Bank of India
Dismissing Risks From Demonetisation, Monetary Policy Committee Keeps Hawk Eye On Inflation

All In Sync

The views shared by the three external members of the MPC were similar to those shared by the RBI officials on the committee. Each of the members, all of whom voted in favor of no rate cut, said that they expected the impact of demonetisation to be temporary.

Pami Dua said that leading indicators produced by the Economic Cycle Research Institute showed that the Indian economy was in a “resilient state” ahead of the withdrawal of Rs 500 and Rs 1000 notes. She added that from a business cycle perspective, the Indian economy was not vulnerable.

“In this backdrop, the withdrawal of SBNs is expected to have only a transitory impact on economic activity,” said Dua.

Ravindra Dholakia and Chetan Ghate shared that view.

While the recent developments on SBNs (specified bank notes) can be considered as an exogenous shock to the economy that results in downward revision of the GDP growth forecast, it is widely perceived to be a transitory or temporary phenomenon. If it is so, it is not advisable to respond with a policy intervention that involves longer distributive lags, because otherwise it can destabilise the system or create avoidable uncertainty in policy stance and action in future.
Ravindra Dholakia, Member, Monetary Policy Committee
Dismissing Risks From Demonetisation, Monetary Policy Committee Keeps Hawk Eye On Inflation

The Interest Rate Outlook

Despite the tough stance taken by the MPC committee on inflation risks, economists still see scope for more rate cuts.

In a note issued after the MPC minutes were released, Nomura Global Markets said that while they agree with the view that the growth hit due to demonetisation will be temporary, they expect the impact to be deeper than what is being suggested. Nomura added that demonetisation contributed 25-30 basis points (bps) to the fall in retail inflation in November, higher than the RBI’s estimate of 10-15 bps.

“In this backdrop and barring any major global disruption, we believe growth and inflation readings will be supportive of policy easing. As such, we expect the RBI to cut the repo rate by 25 bps to 6 percent in February and stay on hold thereafter, once the transitory effects start to fade,” said Nomura.

Yes Bank expects a steeper 50 bps cut by April 2017.

The announcement of FY18 Union Budget and low likelihood of inflation risks in our assessment will create room to support growth. As such, we continue to anticipate 50 bps cut in the repo rate by April 17. However, any further easing is unlikely with MPC’s focus shifting towards the medium term inflation target of 4 percent.
Yes Bank Research