Why The RBI Will Likely Keep Rates On Hold: Morgan Stanley
For the fifth time in this financial year, the members of the Monetary Policy Committee will meet to discuss India’s economic outlook and set the course for the country’s monetary policy. The consensus is expecting rates to be kept on hold and hence the key debate has shifted to whether the MPC will maintain its neutral stance or turn more hawkish.
To determine the likely outcome of the MPC’s decision on Dec. 6, we pick up the debate from where the MPC left off at its previous meeting. Our read from the minutes of the last meeting revealed three issues that were at the heart of the MPC’s debate:
- the outlook for inflation and potential upside risks;
- whether the growth slowdown in the April-June 2017 quarter would be transient or sustained; and
- the appropriate monetary policy response to these developments.
Taking a closer look at these three key debates in turn:
Inflation Outlook: Are There More Upside Risks?
At the last meeting, the MPC noted that headline Consumer Price Index inflation had been rising on a broad-base, and its assessment was that inflation would likely rise further. Since then, headline inflation has climbed higher, from 3.3 percent in August to 3.6 percent in October, and the upside risk factors that the MPC was monitoring had all moved in support of higher inflation.
International crude oil prices have firmed and the Rabi crop sowing activity was off to a weak start, while the central government’s fiscal deficit continued to track at 3.9 percent of gross domestic product (above the target of 3.2 percent).
From here, the inflation trajectory is expected to rise given further increases in food and fuel prices, continued impact of the house rent allowance and implementation of pay commission-related hikes.
Against this backdrop, the MPC is likely to retain its assessment that headline inflation would track above 4 percent for the second half of the fiscal year.
Growth Outlook: Has Growth Troughed?
On the growth front, the MPC noted the sluggish growth print of 5.7 percent in the April-June quarter but did not conclude decisively if the slowdown is transient or would be sustained, with most members citing a need to monitor the incoming data. Since then, GDP growth has recovered to 6.3 percent year-on-year in the July-September quarter, thereby reaffirming the view of some MPC members that the April-June quarter marked a trough in the growth cycle.
In addition, high-frequency indicators are suggesting that activity picked up further in October-November, which would be in line with the MPC’s assessment of an improving growth trajectory.
The headwinds to growth are abating and hence should support the MPC’s assessment that GDP growth will move above 7 percent in the second half of the fiscal year.
Policy Response: What Is The Role For Monetary Policy?
In the previous meeting, the economic backdrop of a slowdown in growth and rising inflation meant that the MPC had to weigh the balance between whether downward pressures on growth would continue or if more factors would impart upward pressures to the inflation trajectory. The majority of the MPC voted to keep rates on hold at that meeting, with the RBI members recognizing the risks to achieving the 4 percent inflation target on a durable basis, while on the growth front, most of the members adopted a wait-and-watch strategy so as to be able to determine whether the growth slowdown was temporary.
As discussed above, the out-turn of the growth and inflation data points post the MPC meeting has likely reaffirmed the views of the majority of the MPC and in turn validated the decision to keep rates on hold and maintain its neutral stance.
From a broader perspective of achieving the inflation target while supporting growth, the MPC had been emphasising the role of monetary transmission and was cognizant of the need to boost investment activity. On these issues, members of the MPC have on multiple occasions in the past stressed the importance of the resolution on non-performing loans and the adequate recapitalisation of state-owned banks. Members have also highlighted the positive impact that closing the infrastructure gap and simplifying the GST would have.
Since then, developments on this front have also been supportive in encouraging a potential revival of investment activity.
The government has announced a bank recapitalisation plan to infuse Rs 2.1 lakh crore ($32.5 billion) of capital into state-owned banks. This, in our view, would help accelerate the non-performing loan resolution process, remove the potential tail risk of the banking system dragging on growth, boost investors’ and domestic corporate sentiment and, most important, improve the overall banking system’s ability to meet investment credit demand.
Other policy developments have been encouraging as well. The government has announced an infrastructure push, while the GST Council has taken up a further simplification of the tax system with the rationalisation of tax rates and changes to reduce the tax compliance burden, particularly on small and medium-sized enterprises.
A Reduced Need To Act
In sum, the evolution of the macroeconomic and policy backdrop since the last MPC meeting has arguably reduced the need for the MPC to act. We, therefore, expect the MPC to keep rates on hold and maintain its neutral policy stance at the Dec. 6 meeting.
Beyond the Dec. meeting, given the growth recovery and cyclical rise in inflation that both we and the RBI are projecting, we do not expect any further easing measures by the MPC, and we look for the neutral stance to be maintained for longer.
With improving capacity utilisation and a narrowing of the output gap over time, the inflation trajectory should be on an upward path, and the upside risks should begin to build. Against this backdrop and given the MPC’s commitment to the inflation target, the next move by the central bank will likely be to commence on a rate hike cycle, likely from the second half of the 2018-19 financial year.
Derrick Kam is Morgan Stanley’s India economist, Chetan Ahya is global co-head of economics and chief Asia economist at Morgan Stanley.
The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.