Monetary Policy: RBI Provides Its Strongest Forward Guidance
There should be no ambiguity as to RBI’s policy objectives from here on, write Barclays’ Rahul Bajoria and Shreya Sodhani.
The lead up to today’s Monetary Policy Committee meeting was considered a Hobson’s choice by some market commentators. There was no alternative but to cut rates, though, in that choice, the Reserve Bank of India had some optionality to send a nuanced signal: cut a lot, and risk some members turning neutral, and confusing the markets about the future of the cycle. Cut too little, and the market may believe the easing cycle to be over, and reprice the entire rates curve.
Amid this set of similar but slightly distinguished decision sets, the MPC has done well to send a coherent message, delivered a unanimous decision to cut rates, but by 25 basis points to bring the repo rate to 5.15 percent and maintained an accommodative stance. More so, RBI has used its strongest language so far, promising to keep an accommodative stance as long as it is necessary to revive GDP growth, while maintaining inflation within its policy target band.
There should be no ambiguity as to RBI’s policy objectives from here on. The common assertion of the MPC to revive growth is clear, the market should heed RBI’s increasing the span of its easing cycle.
We expect RBI to cut rates again at least twice, by 25 basis points following from its December meeting, and by another 15 basis points in February, bringing the terminal repo rate to 4.75 percent.
On top of this, RBI will also likely maintain its accommodative stance through the current fiscal year, and potentially next year, giving banks and markets the confidence that rates are likely to stay low for some time.
Better Transmission
Today’s guidance also sends a message to commercial banks to accelerate transmission, albeit through signals. RBI noted today that of the 110 basis points of cuts delivered between February and August, only 29 basis points of transmission had taken place. But the assurance of future rate cuts and a relatively long period of low rates should help assuage issues of interest rate mismatch between deposits and loans, and stiff competition from alternative savings instruments, which remain as impediments for transmission.
To ensure better pass-through of rate cuts, a sustained liquidity surplus is also likely to be maintained.
However, the governor was measured today in his guidance on liquidity but did play down the recommendations of RBI’s internal working group, which suggested that the system should maintain a small liquidity deficit in normal circumstances. Further, with external benchmark-linked lending rates going live this week, the marginal pass-through should start to improve from the ongoing quarter. We maintain that implementation will likely take time for the stock of loans to switch over to the new regime.
Balancing Priorities
Conspicuously, for an inflation-targeting central bank, the focus on the Consumer Price Index remains low, and for good reasons. India’s CPI inflation has stayed below 4.0 percent for thirteen straight months and is likely to broadly stay in check for the next 12 months. Global commodity prices, weather variations, a stable rupee, and weak demand all point to limited inflation risks. As such, putting GDP growth at the centre of the policy deliberation is sensible. RBI today reduced its GDP forecast by 80 basis points for FY20, the biggest revision in GDP forecast we have seen in a long time. Not just that, the RBI has also flagged a widening negative output gap since February this year, and according to its monetary policy report, the output gap stood at -0.75 percent of GDP in Q1FY20, levels not seen since the end of FY15.
Extending the output gap analysis using RBI’s GDP projections, it is likely that the negative output gap will likely bottom sometime in Q4FY20, and will stay negative for most of 2020 as well, thus underpinning the guidance to maintain an accommodative stance as long as it is necessary.
Fiscal Concerns
There are limited risks to RBI’s near term projections, but we think that the fiscal outlook can potentially become an area of disagreement between MPC members going forward. While the RBI and Governor Das did not express any concerns about the fiscal position today, at earlier meetings, members have had varied opinions about the fiscal picture – ranging from “worry” to “not a matter of concern”. The governor recently cautioned that the government has limited space to boost growth. Following the recent reduction in corporate tax amid sluggish GST collections, anxiety around fiscal position is expected to increase, even after accounting for the large RBI dividend.
We expect fiscal deficit for the current fiscal year to widen to 3.8 percent of GDP unless the government lays out alternate sources of revenue.
Looking ahead, apart from addressing the growth slowdown, the RBI governor sent a clear message that financial stability risks will be handled swiftly and deftly. The message should help assuage concerns about the state of cooperative banks and recent RBI actions, and help impress upon the public and others that RBI remains in a state of constant vigil as far as monitoring financial stability risks as concerned.
Rahul Bajoria is Chief India Economist, and Shreya Sodhani is Economist, at Barclays.
The views expressed here are those of the author and do not necessarily represent the views of Bloomberg Quint or its editorial team.