Monetary Policy: There Still May Be Space For More Easing
The RBI headquarters in Mumbai. (Photographer: Kainaz Amaria/Bloomberg)

Monetary Policy: There Still May Be Space For More Easing


The expectation from the Reserve Bank of India’s upcoming Monetary Policy Committee meeting later this week is nearly unanimously in favour of a pause on the policy interest rates. The MPC voted 6-0 in favour of a pause in the last meeting in early-December when the then-latest (October) CPI inflation print stood at 4.6 percent. As against that, currently, CPI inflation for December stands at 7.4 percent – thereby, virtually ruling out the possibility of a rate cut in the February MPC meeting.

How Grave Is The Inflation Scenario?

The MPC will certainly remain vigilant given the sudden spike in CPI of late – from 4.0 percent in September to 7.4 percent in December. The latest print is materially higher than the upper limit of the CPI target band of 6 percent and the next couple of readings might remain at uncomfortably high levels. Nevertheless, one expects the MPC to take a more holistic approach while analysing the inflation scenario.

First, while the headline CPI spiked during October-December 2019, it was driven primarily by a small number of items, mostly perishable food items.

Core CPI inflation is still soft, in the sub-4 percent zone.

CPI ex-vegetables stood at 3.7 percent year-on-year in December. The weight of vegetables in the CPI basket is around 6 percent. In fact, the spike in onion prices alone—weight sub-1 percent in the CPI basket— contributed nearly 200 basis points in the current CPI inflation reading. Overall, while the headline CPI surged dramatically during Oct.-Dec. 2019 due to spike in prices of a few items – primarily perishable food items such as vegetables, mostly reflecting weather issues and short-term supply disruptions – the broader inflation basket is not showing signs of demand overheating.

Pricing power for several industrial commodities remains modest, as reflected in a WPI inflation reading of 2.6 percent year-on-year in December.

Admittedly, global food inflation has moved higher of late and correlation of Indian food inflation with the former is often strong. Nevertheless, normalisation of prices of the one or two key food items (most notably, onion) that have primarily swung the needle for retail inflation of late, should create a decent buffer for CPI to absorb pressures to an extent. Also, given the key source of pressure has emanated from a few short-cycle crops, the possibility of normalisation in prices of the same in the coming months is relatively higher.

Output Gap To Persist, Modest Growth Support From Budget

The Q2FY20 GDP print of 4.5 percent, at a multi-year low, reflected weakness in several pockets in the economy. GDP excluding government spending grew sub-3 percent year-on-year. Nominal GDP growth – at around 6.0 percent – also tanked to a multi-year low and remains a major headwind for near term business sentiment. Expectations of better GDP growth in 2020 are based primarily on a likely normalisation in private consumption, which had witnessed a sharp drop in recent quarters. Expectations from the other engines of growth, like investment and net exports, remain muted. Overall, recovery in economic activities will likely be only gradual, suggests a host of lead indicators.

Accordingly, despite expectations of some uptick in growth, the negative output gap looks set to persist for several quarters.

In the Union Budget presented recently, the Finance Minister attempted a difficult balancing act with the budget generating only modest near term growth support while containing fiscal slippage within reasonable limits. The success of the current set of initiatives announced in the budget will depend on their execution over time. A number of these measures attempted to address a set of relevant issues and, if executed well, will likely help more inclusive and sustainable growth over time. However, it will be unrealistic to expect the budget to lead to a major turnaround in the near term growth momentum.

Also read: MPC Meet: “Temporary Pause” In Rates May Extend Into Next Fiscal Year

RBI Might Not Have Exhausted Room For Monetary Action

Even if the possibility of a rate action is virtually ruled out in the February meeting, the MPC commentary will likely play an important role in gauging the RBI’s bias for future policy. Beyond the outcome of this week’s meeting, the key question is that, having brought down the repo rate already to 5.15 percent, whether any further room is left for the RBI to ease further even over the medium-term horizon.

Historically, over the past 15 years, the RBI had lowered the repo rate below the 5 percent mark only once and stayed there for a period of less than one year.

However, the basic macro backdrop in recent years is significantly different:

  • Inflation momentum has been materially softer in recent years,
  • The typically strong demand-side support to the Indian growth story seems to be facing headwinds,
  • Business and consumer confidence seem to have weakened considerably of late, while
  • Twin deficit threats have been relatively benign.

Against such a backdrop, one feels that the RBI might not have necessarily exhausted the policy space for some more monetary easing.

But RBI Will Certainly Wait For A More Opportune Time

After 135-basis points repo rate cuts during 2019 and a strong infusion of systemic liquidity, the bar for further easing has certainly moved higher, especially given the spike in CPI in recent months. Rather than delivering anything in a rush, the MPC will likely wait for a more appropriate time for further easing to be more effective in terms of better transmission. Bond market trends and sentiment will likely play a non-negligible role in that consideration.

In that context, one notes that the government’s sticking to the 2019-20 market borrowing target is a near-term sentiment positive for the bond market. The fiscal deficit target of 3.5 percent of GDP for 2020-21 is also in line with expectations.

However, repeated overshooting of deficits beyond their budgeted levels in recent years—and question marks around the viability of the fiscal arithmetic—will likely result in continued uncertainties in bond market sentiment during 2020-21.

Also, funding of the 2020-21 fiscal deficit will hinge critically on proceeds from small savings, as revealed by the budget arithmetic. It might prompt the government to keep the small savings rate relatively high, which might be a stumbling block for bank interest rates to soften in the near term.

Siddhartha Sanyal is the chief economist and head of research at Bandhan Bank.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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