RBI plays ball by cutting rates

As many as 32 economists out of the 43 surveyed by a news agency a day before expected the MPC of RBI to keep the policy repo rate unchanged at 6.5 per cent, while changing the policy stance from ‘calibrated tightening’ to ‘neutral’ in its sixth and last bi-monthly meeting for 2018-19.

But as it turned out, the MPC decided 4-2 in favour of a rate cut by 25 basis points. The RBI had raised the policy rates twice last year and although in the last two bi-monthly meetings, the MPC did not tweak the rate, it changed the stance from ‘neutral’ to ‘calibrated tightening’ in the fourth meeting in early October 2018. The markets were not taken entirely by surprise, though. The yield on the 10-year benchmark bond dropped only by 7 basis points after the policy announcement.

Rate cut rationale

The case out made by the RBI in support of the rate cut as also the reversal of stance is simple and straightforward: inflation has behaved unexpectedly well since the fifth policy and the overall demand conditions are moderate on the back of a slowdown in private and public consumption expenditure. In the MPC’s view, there is a modest output gap and public spending on infrastructure alone cannot support investment activity. Hence, there is a need to strengthen private investment activity and buttress private consumption.

What has changed in the inflation and growth outlook since the last policy?

The CPI inflation has been projected at 3.2-3.4 per cent in H1:2019-20 and 3.9 per cent in Q3:2019-20, with risks broadly balanced on both sides. At the time of the fifth bi-monthly meeting, the projection for H1:2019-20 was at 3.8-4.2 per cent, with risks tilted to the upside.

The RBI sees the actual GDP growth for 2018-19 to be a bit less than the projected 7.4 per cent. Its projection for 2019-20 in this regard is also 7.4 per cent. In the last meeting, the projection for H1:2019-20 was at 7.2-7.4 per cent.

On the whole, the inflation projection for the next fiscal year is better now, ‘reflecting the current low level of inflation and the benign food inflation outlook’. Given the current high volatility in the prices of several food items like vegetables, it will be unrealistic to expect too many surprises on the downside of their prices in a row.

The growth outlook is broadly the same as before. The policy statement presents a fairly positive picture on the outlook for the agriculture, industries and services sectors. Despite indicating some moderation in activity, it does not point to the existence of any noticeable slack in the economy.

For example, the capacity utilisation in the manufacturing sector, as measured by the RBI’s order books, inventory and capacity utilisation survey, increased to 74.8 per cent in Q2:2018-19 from 73.8 per cent in Q1; the seasonally adjusted capacity utilisation also improved to 75.3 per cent from 74.9 per cent during this period. The manufacturing purchasing managers’ index (PMI) for January 2019 remained in expansion on the back of increased output and new orders.

The services PMI continued to expand in January 2019. Indicators of the construction sector —consumption of steel and production of cement — continued to show healthy growth.

Given the foregoing, it is doubtful if a full-fledged policy reversal was necessary now. Central banks do not change their monetary policies by fits and starts. Also, monetary policy formulation is not about finding scope and assembling justifications for making rate cuts.

Inflation falls, expectations high

At the time of the fifth bi-monthly policy in December 2018, CPI inflation for 2018-19 was projected in the range of 2.7-3.2 per cent in H2:2018-19 and 3.8-4.2 per cent in H1:2019-20, with risks tilted to the upside.

The actual inflation outcome at 2.6 per cent in Q3:2018-19 was a tad lower than the projection. As regards the monthly CPI inflation print, it fell from 3.4 per cent in October 2018 to an 18-month low of 2.2 per cent in December 2018. The decline was due to a broad-based softening of prices of several constituents of food groups, as also fuel and other items figuring in the inflation gauge.

The so-called core inflation — CPI inflation — excluding food and fuel decreased to 5.6 per cent in December from 6.2 per cent in October. As measured by the December 2018 round of the RBI’s households’ inflation expectation survey, while the inflation expectations for the three-month horizon eased by 40 basis points from 9.4 per cent to 9.0 per cent in relation to the previous survey in September 2018, that for the 12-month horizon remained unchanged at 9.8 per cent.

Intuitively, the decline in three-month expectations reflects its adaptive nature against the backdrop of falling food and fuel prices. Further, in the last published quarterly Industrial Outlook Survey of the Manufacturing Sector for Q2:2018-19, the percentage of respondents who expected a rise in the cost of raw materials in Q3:2018-19 rose to 46.5 per cent from 46.2 per cent in the previous quarter.

The upshot is that inflation expectations are still high, a fact which puts paid to the oft-heard view that the real interest in India is one of the highest in Asia. It is fashionable in this country to blame ‘high interest rates’ for the muted credit flows to the industrial sector. In reality, this phenomenon has its provenance in the twin balance sheet problem, which is still unresolved.

The suite of developmental and regulatory policy initiatives announced alongside the policy is timely and progressive. Of special significance to the financial markets is the proposal to study the offshore Rupee markets and to rationalise the regulations on the interest rate derivatives. The first one will hopefully throw some useful light on the role of the off-shore markets in the discovery of the external price of the Rupee, on the one hand, and the channels through which the on-shore and off-shore markets are linked.

A need for the second initiative has long been felt, since the current phalanx of regulations are mostly outdated and discordant. An overhaul in this regard is needed to vitalise the interest rate derivatives market in India.

A ‘regime shift’ in RBI?

This policy comes in the aftermath of a leadership change in the RBI and the presentation of an expansionary ‘interim Budget’. The policy statement makes only a passing and perfunctory reference to the inflationary impact of the Budget.

In fact, soon after the Budget was presented, there were well-publicised opinions that its aims would remain unachieved if the RBI did not cut policy rates to boost investment in the economy.

In a rather curious and somewhat intriguing sequence, all the major demands made on the RBI before the leadership change viz. relaxation in PCA norms, payment of a large amount by way of interim dividend to the Centre and easing of the policy rate have now been acceded to.

Whether these are connected or independent events, only time will tell. As for the MPC, these are its early days yet, and it should be unwavering in steadfastly adding to the impressive credibility that it has amassed so far.

The writer is a former central banker and consultant to the IMF. (Through The Billion Press)

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