MPC Meet: Does The Government’s Fiscal Push Change Rate Cut Expectations?

India’s Monetary Policy Committee is seen cutting rates once again as demand in the economy remains weak. A fall in GDP growth to a six-year low of 5 percent and modest inflation has left room for the MPC to pare rates for the fifth time this year.

The committee will, however, need to take note of the government’s decision to cut corporate tax rates. The move will likely expand the fiscal deficit beyond the targeted 3.3 percent of GDP for FY20.

Still, a Bloomberg poll of 25 economists shows that the repo rate will be cut by another 25 basis points to 5.15 percent when the committee meets on Oct. 4, 2019. Some economists also see the possibility of a larger cut in rates of up to 40 basis points.

So far this year, the MPC has cut rates by 110 basis points.

Growth-Inflation Dynamics Call For Lower Rates

High-frequency indicators for the July-September quarter have remained weak, suggesting that demand conditions in the economy remain muted.

Industrial output rose in July to 4.3 percent from 2 percent in June. Internals of the data showed that consumer durables output shrank and consumer non-durables saw strong growth. Capital goods continued to contract.

Imports declined 13 percent in August after falling 10 percent in July. Other signs of weak demand are visible in modest growth in bank credit, which has fallen to 10 percent.

Weakening growth has weighed down inflation.

Retail inflation stood at 3.21 percent in August compared to 3.15 percent in July. Manufacturing inflation, as measured by the wholesale price index, fell to zero in the latest reading suggesting limited pricing power in the hands of manufacturers.

Each of these factors is likely to force the Reserve Bank of India to cut its growth forecast of 6.9 percent for FY20 and will likely prompt the MPC to continue cutting rates, say economists.

Prachi Mishra, chief India economist at Goldman Sachs also expects a 25-basis-point rate cut in October and sees the RBI cut its FY20 growth forecast to between 6 percent and 6.5 percent. Mishra, however, sees inflation move up to 4 percent by December, diminishing the case for further rate cuts.

“GDP growth for the first quarter at 5 percent is much lower than RBI and market expectations. Importantly, core CPI has continued to moderate along with other advance indicators, thereby pointing towards a continuing negative output gap,” said Indranil Pan, chief economist at IDFC Economic Research, in a note on Friday. The research house expects another 40 basis points in rate cuts in FY20, with a 25-basis-point cut likely to be delivered this week.

Do The Tax Cuts Change The Rate Cut Math?

Even though growth-inflation dynamics call for lower rates, the MPC will need to take into account the government’s decision to cut corporate tax rates.

The decision is likely to expand the fiscal deficit beyond the targeted 3.3 percent of GDP.

Typically, a wider fiscal deficit would give the RBI cause for concern. Economists, however, believe that since the government’s decision is not in the form of a direct consumption stimulus, any upside impact on inflation will be limited.

Pranjul Bhandari, chief India economist at HSBC estimates that the fiscal impulse generated by the tax cuts will not be large enough to close the output gap, suggesting that rate cuts will continue.

“We calculate the fiscal impulse to be 0.5 percent of GDP in FY20 compared to a drag of 0.2 percent of GDP in FY19,” Bhandari wrote in a note on Monday. With the output gap estimated at a large 0.7 percent in the quarter ended June 2019, the fiscal impulse will not be large enough to close the output gap, Bhandari said. She expects two 25 basis point rate cuts in October and December, taking the policy rate to 4.9 percent.

The focus of fiscal stimulus is capex-driven rather than consumption-driven and thus poses limited risks to macro stability, said Upasana Chachra, economist at Morgan Stanley, in a research note dated Sept. 22, 2019. Chachra expects inflation to remain under the MPC’s target though expectations over the number of rate cuts have tempered.

Neelkanth Mishra of Credit Suisse argues that the government’s decision to cut corporate tax rates will help in bringing down inflation over the medium term by adding to supply. As such, he said the MPC should continue cutting rates.

“If it is just pure consumption stimulus, it would be inflationary. Especially if funded by RBI’s open market purchases. Whereas something that adds to capacity, potentially, and the cuts are funded by curtailment of expenditure, is actually negative for inflation,” Mishra told BloombergQuint in a recent interview. “This should mean lower interest rates a year out,” Mishra added.

Hoping For Improved Transmission

The MPC will also be keeping an eye out for improved transmission of lower policy rates.

After a few months of back and forth, the RBI has asked all banks to move to external benchmarking of floating rate loans to retail and SME customers from Oct. 1. This could help bring down lending rates in the system to some extent.

Given that banks continue to face inflexibility on the liability side, a large move by the RBI in one go could have implications for banks profitability, they added.

So far transmission of policy rate cuts has remained weak.

While the repo rate has been pared by a cumulative 110 basis points since February this year, the weighted average lending rate on fresh loans by scheduled commercial banks fell from 9.81 percent in February 2019 to 9.77 percent in July 2019. The one year marginal cost of lending rate fell by 30 basis points from February to August 2019.