A security guard stands in the RBI building in Mumbai. (Photographer: Karen Dias/Bloomberg)

Monetary Policy: Why The RBI Should Bite The Rate Cut Bullet


Will the Reserve Bank of India shift gears? That is the big question heading into Thursday’s monetary policy announcement.

To be sure, the balance of risks has shifted firmly to the downside since last October, when the monetary policy committee unanimously agreed to change the policy stance to ‘calibrated tightening’ from ‘neutral’, citing upside risks to inflation.

Headline consumer inflation has slipped close to the bottom of the central bank’s 2-6 percent target range over the last couple of months. ‘Core-core’ inflation (CPI excluding food, fuel, and motor fuels), does remain close to 6 percent, led by elevated health and education costs. But sticky core prices partly reflect the lagged pass-through of earlier cost pressures and risks on this front have now receded, given the more benign outlook for oil prices and the rupee this year.

Moreover, downside pressures on growth have risen, which should act as a drag on core inflation further out.

Also read: Monetary Policy Meet: Did India Pick The Right Inflation Target?

Despite moderating oil prices, domestic demand has come under pressure since late 2018 due to the reduced lending ability of the non-banking financial sector, in the wake of the Infrastructure Leasing & Financial Services default. Consumption indicators have been the first to turn, with both car and two-wheeler sales declining sharply in December, probably due to the sector’s strong dependence on NBFC financing. Investment and overall gross domestic product growth are likely to show a similar trend when national accounts for the third quarter of the current fiscal are released later this month. And while bank credit growth has picked up, it’s unlikely to fill the entire credit gap, given the banks’ own balance sheet and governance issues.

The new MPC, led by Governor Shaktikanta Das, is also likely to have more dovish leanings as compared to the earlier one.
RBI Governor Shaktikanta Das interacts with the media in New Delhi, on Jan. 7, 2019. (Photograph: PTI)
RBI Governor Shaktikanta Das interacts with the media in New Delhi, on Jan. 7, 2019. (Photograph: PTI)

Under Urjit Patel, the MPC’s focus was clearly on anchoring inflation to the 4 percent medium-term target and not responding too much to short-term noise. In practice, this had translated into a mildly hawkish stance over the last two years, with the committee more willing to raise rates in response to rising inflation in 2018, as opposed to lowering rates when inflation was falling in 2017.

Nothing prevents this behaviour from changing. By itself, the monetary policy framework agreement between the RBI and the government allows the central bank a fair amount of leeway in setting policy in the short-run, as long as average headline inflation doesn’t threaten to breach the 2-6 percent range for three consecutive quarters. It states that the “primary objective of the monetary policy is to maintain price stability, while keeping in mind the objective of growth, and to meet the challenge of an increasingly complex economy”. It further adds that the range around the target allows the MPC “to recognise the short run trade-offs between inflation and growth”.

Governor Das’ comments on monetary policy have been few and far between.

Early in 2018, months before he took over as governor, Das had hinted that a low and stable inflation environment allows for lower policy rates, even though inflation was averaging above 4 percent then.

This suggests that he would be amenable to a 25 basis point rate cut and shifting to a ‘neutral’ stance in the current environment.

Also read: Monetary Policy: If Not Cut Now, When?

What Could Then Hold The RBI Back?

Continued fiscal slippages, for one. The interim budget pegged the revised fiscal deficit for FY19 at 3.4 percent of GDP, against consensus expectations of no deviation from the initial target of 3.3 percent. While the slippage, by itself, is marginal, it is the further symptom of weak fiscal discipline that is the worrying feature. For the second year in a row, the government failed to adhere to its budgeted target. It also indicated a pause in fiscal consolidation by keeping the FY20 target unchanged from this year at 3.4 percent of GDP.

More worryingly, risks of future slippage cannot be ruled out either.

The proposed budget for FY20 is truly populist, ahead of the upcoming general elections. As expected, the government has announced a farm package to woo rural votes, using that as a justification to delay fiscal consolidation. But it has not stopped there. It has added to its social schemes by announcing a mega pension scheme for a section of the unorganised sector, rewarded the middle class with unexpected tax benefits and announced sops for the real estate sector, among other things.

The strong pace of growth in expenditure is projected to be largely financed through higher tax receipts, particularly income tax and Goods and Services Tax revenues. It is likely that GST collections pick up in the next fiscal as tax administration improves and lower rates encourage compliance.

But given the disappointing performance so far in FY19, the budgeted numbers appear optimistic.

There is also continued reliance on non-tax revenue, particularly disinvestment proceeds, to plug the deficit gap, which may also surprise on the downside.

In all, the budget math remains open to scrutiny and raises serious doubts about India’s ability to narrow the deficit to 3 percent of GDP by FY21, which the government has committed to under the Fiscal Responsibility and Budget Management Act. Indeed, rating agency Moody’s has already issued a statement saying that it perceives ‘continued slippage as credit negative’ for India.

This unexpected fiscal profligacy could lead the RBI to contemplate a slower path to monetary easing than warranted by economic conditions.

It is important to remember that in his maiden policy meeting, Governor Das, will also face the unenviable task of convincing analysts and investors that the RBI’s core operation—setting monetary policy—will not be compromised under his aegis. The choice of an experienced bureaucrat to lead the central bank, after Patel’s controversial departure in December, was hardly surprising. But his close ties with the government have kept investors worried about the central bank’s independence and the governor may choose to assuage some of these concerns by acknowledging potential fiscal risks.

Nonetheless, this is likely to just delay a rate cut to the April meeting, not take it off the table. While populist expenditure may provide a temporary boost to consumption, the large market borrowing program (gross market borrowings are projected at Rs 7.1 lakh crore, substantially higher than market expectations) will exert upside pressure on bond yields and hurt private investment. Amid already tight monetary conditions, this will keep the economic rationale for a rate cut intact in the first half of 2019.

Priyanka Kishore is Lead Asia Economist at Oxford Economics.

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