Policy Day Guide: Key Questions For The MPC To Debate
Core GVA growth and core inflation may form the backdrop of the MPC’s rate decision today.
The monetary policy committee will deliver its fifth review of the financial year on Wednesday. A poll by Bloomberg News suggests that most economists expect a status quo policy. Forty-one of 46 economists polled expect the repo rate to remain unchanged at 6 percent, while a small minority expects another 25 basis point cut to 5.75 percent.
Most economists also expect the Reserve Bank of India to maintain its neutral stance, giving the central bank flexibility to move in either direction, should economic data throw up any surprises in the coming months.
Growth Rebounding, But Slowly
A key input into the decision will be the pace at which the economy is recovering from the twin shocks of demonetisation and the Goods and Services Tax. At the time of the last policy review, the RBI had cut its gross value added growth forecast for the fiscal year sharply to 6.7 percent compared to 7.3 percent earlier. It had expressed hope that growth will pick up in the second half of the year aided by consumer spending and a quicker rebound in services.
Growth indicators that have come in since its October review, however, will not allow for a decisive view on how quickly growth is recovering.
Second quarter growth data shows that the economy grew at 6.1 percent in GVA terms. However, that data when deconstructured threw up some surprises. Firstly, core GVA growth, which excludes agriculture and government spending, rebounded more strongly than headline growth. This suggests that while private enterprise may be rebounding as expected, strains on government finances and the agriculture sector are weighing down growth. Lower interest rates will do little to help those two segments.
But the debate doesn’t end there for there were other surprises too. Growth in personal consumption expenditure was at its weakest in eight quarters. Growth in gross fixed capital formation, however, was at its best in four quarters. Manufacturing grew at a strong 7 percent but this contradicted the weakness in the industrial output data. Purchasing managers’ data also threw up some surprises with manufacturing growing strongly in November, while services contracted.
The short point being that the growth outlook remains uncertain. Should the MPC judge that these uncertainties have risen and the negative output gap may widen, it could surprise the market with a rate cut.
Inflation Subdued, But Rising
The inflation picture is almost as unclear.
Headline retail inflation is rising gradually but remains, at least for now, below the RBI’s projected range of 4.2-4.6 percent for the second half of the year. In October, consumer price inflation was at 3.6 percent. Just like the growth picture, there is a distinction between headline inflation and core inflation. In this case, while headline inflation remains subdued, core inflation is holding at close to 4.5 percent.
There are also risks on the horizon. The most notable one being higher commodity prices. Brent crude prices are holding at above $60 per barrel and, in conversations, commodity analysts don’t rule out a rise towards $70 per barrel if supply disruptions emerge. Other input prices have also been on the rise.
In addition, there is the risk of fiscal slippage to contend with. In a heavily debated forecast, the RBI at the time of the last policy had said that a 50 basis point expansion in fiscal deficit in FY18 could push inflation higher by 25 basis points above the baseline scenario.
Could all these risks push inflation further away from the mid-point of the inflation target of 4 percent (+/- 2 percent) if not this year, then the next? That’s a question that the MPC will spend considerable time debating before it makes its decision.
Liquidity Tightening, But Management Is Key
While any change in the MPC’s stance on growth and inflation will be closely watched, the bond market may move more immediately on the RBI’s stance on liquidity.
Over the past few months, banking sector liquidity has tightened considerably. There is still surplus cash but the excess liquidity that flooded the system post demonetisation has all but dried-up. Tightening liquidity has come with concerns over a heavy supply of government bonds.
Until recently, the RBI was continuing with open market bond sales to suck out surplus liquidity. It cancelled one such sale on Nov. 17 to calm the bond market when yields rose back to 7 percent despite an upgrade in India’s sovereign rating, which should have pushed rates lower in the market. While the cancellation of the bond sale calmed nerves for a few days, the benchmark 10-year yield is now back above 7 percent. The fear is that the supply of state and central government bonds will remain heavy in the January-March quarter. The bond market is also expecting the government to increase its borrowings for the year due to a shortfall in revenue collections following the implementation of GST.
The result has been that the 10-year bond yield has risen by 40 basis points since the start of October. Besides, the spread between the repo rate and the 10-year bond yield is now more than 100 basis points. Bond traders say the RBI is not thrilled with this rise in yields and has been speaking to traders to understand the reason for the market’s bearishness.
Against this backdrop, the RBI may try to calm markets by giving an indication that it does not plan to resume open market bond sales and intends to ensure comfortable liquidity conditions. Should it do this, rates (in the market) may fall even if policy rates don’t.
