Monetary Policy: MPC Cuts Rates By 25 Basis Points; Near-Term Outlook ‘Fraught With Risks’ 

India’s Monetary Policy Committee on Friday cut interest rates for the fifth time this year to support growth at a time the central bank believes the near-term outlook for the economy is “fraught with risks”.

The committee decided to pare the benchmark repo rate by 25 basis points to 5.15 percent. Rates have now been cut by 135 basis points since the start of the year. The MPC decided to maintain its stance at ‘accommodative’, “as long as it is necessary to revive growth, while ensuring inflation remains within the target”.

“The MPC notes that the negative output gap has widened further. While the recent measures announced by the government are likely to strengthen private consumption and spur private investment activity, the continued slowdown warrant intensified efforts to restore the growth momentum," the committee said.

All six committee members voted for a rate cut—five of them voted for a 25-basis-point cut, while Ravindra Dholakia voted for a larger 40-basis-point cut.

All 33 economists surveyed by Bloomberg had forecast a cut in rates, though the magnitude varied from 20-40 basis points.

Key Highlights

• MPC cuts repo rate by 25 basis points to 5.15 percent
• MPC to maintain stance at “accommodative "as long as it is necessary to revive growth while insuring inflation remains within target
• All committee members voted for a rate cut; Ravindra Dholakia voted for a 40 basis point cut
• MPC cuts FY20 growth forecast to 6.1 percent from 6.9 percent
• MPC raises inflation forecast marginally, sees inflation at 3.4 percent in Q2 and 3.5-3.7 percent in H2
• RBI raises lending limit for micro finance institutions to Rs 1.25 lakh from Rs 1 lakh
• RBI raises household income threshold for microfinance borrowers from Rs 1 lakh to Rs 1.25 lakh in rural areas; Rs 1.6 lakh to Rs 2 lakh in urban areas
• RBI allows domestic banks to offer foreign exchange prices to NRIs from their Indian books
• RBI allows rupee derivatives to be traded in IFSC

The continued cut in interest rates comes against the backdrop of weak economic growth. The MPC cut its growth forecast for the year to 6.1 percent from 6.9 percent earlier. Growth in the first quarter of FY20 fell to 5 percent. Since then, the committee, said that “high frequency indicators suggest that domestic demand conditions have remained weak”.

The accompanying Monetary Policy report noted that the output gap had turned more negative.

“The near-term outlook of the Indian economy is fraught with several risks. First private consumption, which has supported economic activity is now beginning to slow down due to a host of factors. In this context, the performance of large employment generating sectors like automobile and real estate remains less than satisfactory,” the report said. Recent measures such as quicker recapitalisation, corporate tax cuts and a stressed asset fund for real estate should help, it said.

Over the course of this year, the RBI’s growth forecast for FY20 has fallen from 7.4 percent in February to 6.1 percent now.

“There was room to cut more even today, said Ashima Goyal, member of the Prime Minister’s Economic Advisory Council. “Since we are not seeing any recovery as yet in high frequency data, I would have preferred a 40 basis point cut. But it is alright as they will meet again in December with the new GDP numbers,” she added.

The RBI also acknowledged that bank credit growth has slowed and overall fund flows to the commercial sector have declined. “The recent recapitalisation of public sector banks augurs well for improving credit flow, which are important for reviving private investment activity,” the monetary policy report said. Data included in the report show that flow of financial resources, from both bank and non-bank source, fell sharply in the April-September 2019 period compared with the same period last year.

The RBI said that monetary policy transmission remains weak, adding that the long maturity of fixed rate deposits and high rates of small savings instruments have a role of play in weak pass-through of policy rate cuts.

“As against the cumulative policy repo rate reduction of 110 basis points during February-August 2019, the weighted average lending rate on fresh rupee loans of commercial banks declined by 29 basis points. However, the WALR on outstanding rupee loans increased by 7 basis points during the same period,” the MPC said.

While reducing rates, the RBI continued to take steps to increase the flow of credit to the economy. This time, it raised the lending limit for microfinance NBFCs to Rs 1.25 lakh per eligible borrower from Rs 1 lakh earlier. However, the income limits to be eligible for loans has also been increased from Rs 1 lakh to Rs 1.25 lakh in rural areas and from Rs 1.6 lakh to Rs 2 lakh in urban areas. In August, the RBI has reduced the risk weight for consumer loans, except credit card loans.

Meanwhile, inflation remains in check, allowing the MPC to keep paring interest rates. The committee raised its inflation projections marginally due to a recent rise in food inflation.

The MPC now expects inflation at 3.4 percent in Q2 FY20 and between 3.5 and 3.7 percent in the second half of the year. In the first quarter of FY21, inflation is seen at 3.6 percent.

Consumer Price Index inflation stood at 3.21 percent in August compared to 3.15 percent in July. At current levels, inflation remains below the MPC’s target range of 4 (+/- 2) percent. Core inflation, a better measure of demand driven inflation, has fallen sharply from above 6 percent in October 2018 to 4.2 percent in August.

Monetary Policy Report: On Growth

• GDP growth projected at 6.1 percent in 2019-20
• GDP growth seen at 5.3 percent in Q2, 6.6 percent in Q3, 7.2 percent in Q4
• Output gap has turned more negative; near-term outlook “fraught with several risks”
• Growth expected to recover on base effect, transmission of monetary policy, government measures
• For FY21, structural model estimates GDP growth at 7 percent
• Slowdown in consumption amplified by slowdown in labour intensive export sectors
• Gross fixed capital formation decelerated due to slowdown in private investment, underlined by corporate deleveraging

“GDP growth forecast of 6.1 percent is realistic but it also shows that they have been wrong in the past when forecasting 6.9 percent, said Bhat of Dalton Capital Advisors.

Bhattacharya reiterated the that growth projections and language of MPC warrant intensified actions. According to him, the MPC has indicated that they have significant room to cut more. “And I expect the liquidity would be relatively far more surplus in FY20 than the previous year. Overall I think the monetary policy side would aim to support the fiscal policies far more aggressively than we had initially thought,” Bhattacharya added.

Monetary Policy Report: On Fiscal Pressures For Centre And States

• Major challenge for government finances in FY20 is to stick to budgeted spending and revenue targets
• In order to meet expenditure commitments, revenue generation critical
• Revenue expenditure picked up in July-August 2019 following general election result
• Slowdown in state revenue expenditure seen in Q1 FY19; some pick up seen in July 2019
• Combined gross fiscal deficit of centre and states seen at 5.9 percent in FY20

Monetary Policy Report: On Inflation

• Headline inflation seen below 4 percent in FY20 and early months of FY21
• Inflation trajectory in FY20 characterised by rising food inflation
• Manufacturing firms see input prices as still soft and pricing power is yet to firm up as the cost of finance and salary outgoes remain muted.

Market Reaction To MPC Outcome

The 10 year government bond yield rose by over 5 bps right after the MPC announcement and continues to trade above 6.64 percent. Key stock indices declined, with the Nifty Bank losing a percent. The rupee weakened against the dollar.

WATCH | Ira Dugal in conversation with Pranjul Bhandari, HSBC and Rahul Bajoria, Barclays.