Monetary Policy Day Guide: Weak Growth, Benign Inflation Set the Stage For Another Rate Cut 

India’s Monetary Policy Committee is set to cut interest rates for a second consecutive time on Thursday, as inflation remains in check and high frequency indicators suggest a weakening of growth momentum.

Forty one of the 43 economists polled by Bloomberg expect the MPC to cut the repo rate by 25 basis points to 6 percent. In February, the MPC cut rates by 25 basis points to 6.25 percent. Economists are divided on whether the MPC would change its stance to ‘accommodative’ to signal further monetary policy easing or if they will retain flexibility by holding the stance at ‘neutral’.

Benign CPI Inflation

The MPC, in its February resolution, had acknowledged that actual inflation has been lower than projections. The MPC had projected inflation to remain below 4 percent till the third quarter of the FY20.

The committee had also noted that the output gap has opened up “modestly”.

The data since the February resolution has suggested some pick-up in food prices but headline inflation remains comfortable. CPI inflation stood at 2.57 percent in February compared to a revised 1.97 percent in January 2019.

Since RBI governor Shaktikanta Das has asserted that the committee’s legal mandate is to target headline inflation, economists believe there is still room for lower rates.

Weaker than anticipated food prices continue to bring comfort on the current and near term inflation trajectory, said Shubhada Rao, chief economist at Yes Bank. However, it appears that inflation trajectory is bottoming out, she added. Yes Bank expects a 25 basis point cut in the repo rate on Thursday.

“The continued undershoot of food prices (vis-à-vis expectations) is likely to induce another rate cut at this week’s review. Indeed, markets are now progressively expecting the rate cut cycle to extend beyond April,” said Sajjid Chinoy, chief India economist at JPMorgan, in a report on Wednesday. He, however, cautioned that high core inflation and elevated inflation expectations are red-flags that the MPC must not ignore.

Moderating Growth

With inflation in control, the MPC can focus on growth, RBI Governor Das had indicated at the time of the February review.

Since then, there have been increasing concerns about weakening economic growth. GDP growth has been revised lower by the Central Statistics Office to 7 percent compared to the RBI’s estimate of 7.4 percent. Some of the high frequency indicators too have indicated a deepening slowdown in the economy.

“Whether the current slowdown in India is transient, due to pre-election uncertainty or something structurally deeper needs to be understood, and there are certainly risks of inflation shocks, but it might be worth taking a risk in further cutting rates now, since we do not see conditions reversing anytime soon,” said Saugato Bhattacharya, chief economist at Axis Bank.

Sonal Varma at Nomura also believes that growth concerns are rising and now expects two more rate cuts from the MPC in the current cycle.

Room For A 50 Basis Point Cut?

Some economists believe that the current growth-inflation mix allows for a 50 basis point cut in the repo rate.

Rajeev Malik, founder and managing director of Macroshanti, said there is a strong case for a 50 basis point cut even if the MPC maintains a neutral stance.

However, Bhattacharya of Axis Bank believes a steep 50 basis point cut is unlikely.

“We don’t think the Monetary Policy Committee will vote for a 50 basis point rate cut, although it is likely that one MPC member will recommend it. Fifty basis point rate changes are always crisis moves for central banks, and even a desire to front load the expected continuing rate cuts might be construed as an adverse signal,” he wrote.

Liquidity Framework

Beyond the MPC’s interest rate decision, markets are awaiting on the RBI’s approach towards liquidity in the new financial year. Tight liquidity conditions persisted through most of FY19 and bond market experts believe this prevented the MPC’s February rate cut from being passed through to end borrowers.

“When your inflation is in check and you are looking at growth, you should have surplus liquidity of Rs 60,000 crore to Rs 70,000 crore. But nowadays, the theory is that liquidity has to be negative. I don’t personally agree,” said Jayesh Mehta, treasurer at Bank of America-Merrill Lynch.

The RBI, in March, conducted a long-term forex swap to infuse liquidity by buying $5 billion via an auction. It will hold another such auction at the end of April.

Ananth Narayan, professor at S.P. Jain Institute of Management and Research, said that the issue goes beyond immediate liquidity conditions. The RBI needs to relook at its framework to deal with liquidity. At present, the weighted average call rate is the indicator most closely watched by the central bank to assess liquidity demands of the system.

“The weighted average call rate does not make sense because it does not capture what the market means when they talk about liquidity issues,” Narayan told BloombergQuint during an interview. “There needs to be a change in this framework of measurement of liquidity and the ‘metric’ needs to be amended,” he said while adding that liquidity should be in deficit, neutral or surplus depending on the monetary policy stance.

The monetary policy committee’s decision will be announced at 11:45 a.m. on Thursday.