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Monetary Policy Day Guide: Is The Stage Set For A Rate Cut?

The Monetary Policy Committee will announce its decision on Thursday, amid expectations that the panel will soften its view on inflation risks in the economy. The changed view could either result in a reversal of stance from ‘calibrated tightening’ to ‘neutral’ or a cut in interest rates along with a change in stance.

Eleven of 43 economists polled by Bloomberg expect a 25 basis point cut in rates to 6.25 percent. Most believe that a change in stance is more likely.

The Inflation Conundrum

The probability of a rate cut has risen due to consecutive months of lower than expected inflation.

Headline inflation fell to 2.18 percent in December 2018, led by lower prices of food and beverages. However, core inflation, which strips out food and fuel prices, remained sticky at 5.7 percent. This divergence will lead to an active debate over which measure of inflation the MPC should focus on.

Sajjid Chinoy, chief India economist at JPMorgan, said that if the MPC chooses to focus on its legal mandate of maintaining inflation in a band of 4 (+/-2) percent, it could cut rates. But this rate cut will be a one-off as headline inflation which converge towards headline inflation over a 12 month period.

Pranjul Bhandari, chief India economist at HSBC, said that there are equally good reasons for a pause and a cut. “The fiscal details from the budget, elevated core inflation, a sudden spike in rural health and education inflation, and expectations of the headline rising above 4 percent in the second half of 2019 call for a pause,” Bhandari wrote in a note on Wednesday.

Monetary Policy Day Guide: Is The Stage Set For A Rate Cut?

Also read: Monetary Policy: If Not Cut Now, When?

Mixed Signals Over Growth

The RBI had projected GDP growth for 2018-19 at 7.4 percent. It retained that forecast at the time of the December MPC meet.

However, the first advance estimates by the Central Statistics Organisation have pegged economic growth lower at 7.2 percent. These estimates suggest that growth moderated in the second half of the financial year.

High frequency indicators, particularly vehicle sales and air traffic growth, have also pointed to weakness in demand. Industrial output growth, as measured by the Index of Industrial Production, fell to a 17 month low in November.

Should the MPC weigh this weakness in growth indicators against moderate inflation pressures, it may vote in favour of lower interest rates.

Monetary Policy Day Guide: Is The Stage Set For A Rate Cut?

Also read: Monetary Policy: Why The RBI Should Bite The Rate Cut Bullet

Fiscal Concerns

One factor that could give the MPC reason to keep rates on hold is the government’s fiscal position.

While fiscal consolidation remains broadly on track, the government has chosen to keep fiscal deficit at 3.4 percent in FY20. This is largely because of a planned Rs 75,000 crore cash payout to farmers. The impact of this income transfer scheme on consumption and inflation remains uncertain.

Sops for small and marginal farmers and select tax payers may contribute to positive demand in low-ticket items but is unlikely to impact headline inflation significantly, Kotak Economic Research said in a note.

Edelweiss Research, however, felt that the fiscal dynamics are not very encouraging and could weigh on MPC’s thinking.

Monetary Policy Day Guide: Is The Stage Set For A Rate Cut?

Also read: Monetary Policy Meet: Did India Pick The Right Inflation Target?

Volatility In Oil And Rupee

The MPC will also remain cautious about the direction of oil prices and the Indian rupee.

Brent crude prices fell in late December period but have risen since then and are hovering around $61 per barrel. The rupee has depreciated from 70.4/$ to 71.5/$ now.

As crude oil prices rise gradually, the Rupee is expected to maintain a depreciation trend and trade in the range between 71 and 72 to the dollar in the short term, said Rushabh Maru, research analyst at Anand Rathi. Fiscal slippage risks coupled with election related uncertainty has weighed on sentiment in the currency market, added Shubhada Rao, chief economist at Yes Bank.

Monetary Policy Day Guide: Is The Stage Set For A Rate Cut?

Also read: Monetary Policy Meet: Headline Inflation May Move Higher Towards Core Inflation, Shows JPMorgan Research

Bond Markets Anticipating Rate Cut?

Bond markets have been anticipating a softer monetary policy stance following the lower than expected inflation. However, it is the large scale open market operation bond purchases which have helped bring down bond yields from above 8 percent to 7.36 percent on the new 10-year bond.

Bond rallied on Wednesday ahead of the monetary policy decision.

The bond rally a day before the MPC’s resolution indicates that the markets expect the RBI could deliver a rate cut, said Madhavi Arora, economist at Edelweiss securities. To be sure, the market may also be consolidating after a sharp rise in yields following the budget.

Beyond the MPC meet, the bond markets may go back to focusing on the higher than expected government borrowings planned for FY20. Bond markets are unlikely to see much relief in the near term and the 10-year yield is estimated to range between 7.25 to 7.75 percent in FY20, Arora said.

Monetary Policy Day Guide: Is The Stage Set For A Rate Cut?

Cash Reserve Ratio Cut?

Some market participants are not ruling out a cut in the cash reserve ratio, which currently stands at 4 percent. Such a cut would help address liquidity concerns by releasing cash immediately into the system. A 50 basis point cut in CRR releases close to Rs 60,000 crore.

So far, the RBI has been addressing liquidity concerns through bond purchases under its open market operation programme. It has purchased bonds worth over Rs 2 lakh crore in the current financial year. While liquidity condition is currently close to neutral, it is expected to tighten again in March.

A CRR cut could be on the table to address this liquidity shortage.