Monetary Policy: Growth-Inflation Trade-Off Allows Some More Very Shallow Rate Cuts
Persisting high ‘real’ interest rates provide room for some further, moderate, policy easing, writes Saugata Bhattacharya.
The Monetary Policy Committee voted to cut the repo rate by 0.25 percentage points to 6 percent in the second back-to-back cut after February, voting 4-2. The neutral stance was maintained, but the tone and language seems to be somewhat less dovish than markets had expected. If this perception is correct, the multiple risks visible in the near and medium term would evidently be the basis. This is despite the palpable deterioration in economic conditions since the last policy.
So how much more, if at all, can the MPC cut the repo rate going ahead? Given the somewhat conflicting signals emanating from the current economic data and financial markets, a large part of the interest of analysts in this review derived from the Reserve Bank of India’s and MPC’s interpretation of the current and future state of economic activity.
The actions will be very data-driven and RBI economic forecasts are a strong signal. As expected, FY20 GDP growth forecast was lowered to 7.2 percent from 7.4 percent in February. Note that this slight improvement from the 7 percent growth estimate for FY19 embeds the effects of the policy stimuli – largely monetary, but also some fiscal.
The fundamental growth impulses are still less than optimal. The output gap, using various analytic metrics, “remains negative”, and “the domestic economy is facing headwinds, especially on the global front”.
Various risks to prices are pointed out – reversal of vegetable prices in the summer months, hazy outlook for oil prices, swift resolution of trade tensions, elevated core inflation, volatile financial markets, etc. However, the base inflation forecast for FY20, 3.2-3.4 percent, was slightly lowered from the February forecasts.
Even with a perfect storm of shocks, inflation is unlikely to breach the 4 (+ 2) percent inflation target’s upper limit.
RBI surveys are equally important components in shaping the MPC rate actions. Current readings are providing somewhat contradictory signals. Household inflation expectations surveys are one of the most closely monitored responses by all central banks, since this indicates how well anchored inflation expectations are, setting the stage for a wage price spiral, up or down. The survey responses for three-month and one-year horizons fell 40 basis points in the February round versus the previous one.
Surveys of business conditions provide insights on corporate expectations of economic activity. The seasonally adjusted capacity utilisation rate rose to 76.1 percent in Q3 FY19 from 75.4 percent in Q2, still showing tight operating conditions, suggesting a potential risk of a surge in manufacturing corporate pricing power, with implications for rising core inflation.
However, this level needs to be interpreted carefully, given that it is backward-looking and that the bulk of the current slowdown was evident only in Q4, thereby resulting in a drop in the capacity utilisation level responses in the next survey round.
A more forward-looking set of responses are from the Business Expectation survey.
Two things.
- First, the drop in business assessment in Q3 (actual conditions) is somewhat at odds with the rise in capacity utilisation (although the data and measurement might be of different aspects).
- Second, there is a clear drop in the business assessment for Q1FY20, which is consistent with our view of a weakening of sentiment.
How much of the current slowdown in economic activity and shift in sentiment might be due to pre-election uncertainty and how much for structural reasons needs to be better understood, and will guide policy going forward.
One signal might be from households. RBI Consumer Confidence survey responses belie the sense of uncertainty. Both the current situation and future expectations responses show fairly strong moves up in Q4 relative to Q3, and is contrary to the slowdown narrative.
How the growth-inflation trade-off plays out over the next few months will determine future MPC responses, but our sense is that persisting high ‘real’ interest rates warrant and provide room for some further, moderate, policy easing. However, the next MPC review in June will probably vote for a pause, assess the election results, the full FY20 union budget, the rains, global and domestic activity, before the next move in August.
Saugata Bhattacharya is Chief Economist at Axis Bank. Views are personal.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.