Monetary Policy Review
Nirmal Bang
Teresa John, CFA
Research Analyst (Economist)
February 08, 2019
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RBI Changes Stance To Neutral And Cuts
Rates By 25bps
The Monetary
Policy Committee (MPC) of the Reserve Bank of India (RBI) voted unanimously
to change its stance to neutral, while four members of the MPC voted for a
rate cut. Dr. Chetan Ghate and Dr. Viral V. Acharya voted to keep the policy
rate unchanged. We, along with consensus, had expected a change in the stance
to neutral, to be subsequently followed by rate cuts.
Lower-than-expected
inflation, concerns over sluggishness in domestic growth, and slowing global
growth aided the RBI’s decision for a rate cut. The central bank has revised
downwards its inflation forecast for 4QFY19 to 2.8% from 2.7%-3.2% for 2HFY19
earlier. The inflation forecast for 1HFY20 has also been lowered to 3.2%-3.4%
from 3.8%-4.2% earlier. Our forecasts are lower at 2.6% for 4QFY19, and 3.1%
for 1HFY20.
Our forecast for 3QFY20 at 4.0% is a tad higher than the RBI’s
3.9%. Moreover, 3-month ahead inflation expectations have softened by 80bps,
while it has softened by 130bps for the 12-month ahead period. GDP growth for
FY19 is pegged at 7.2% by the Central Statistical Office (CSO) compared with
the RBI’s earlier forecast of 7.4%, while the RBI’s forecast for FY20 stands
at 7.4%. Our numbers for FY19 and FY20 stand at 7.2% and 7%, respectively.
The MPC statement noted that the output gap has opened up modestly as actual
output inched lower than its potential. Investment activity is recovering,
but supported mainly by public spending on infrastructure. The need is to
strengthen private investment activity and buttress private consumption.
With
the latest 25bps rate cut, we see room for another 25bps cut in 1QFY20
(mostly in April 2019) with inflation likely to remain muted in 1HFY20. The
RBI does not see near-term risks to inflation from the interim budget
proposals to boost farm income. The MPC statement noted that several
proposals in the interim Union budget for 2019-20 are likely to boost
aggregate demand by raising disposable income, but the full effect of some of
the measures is likely to materialise over a period of time. However, in our
view, the scope for sustained rate cuts may be curtailed by lower
transmission capability on the part of banks.
With the credit-to-deposit
ratio at around 77.8%, banks will have to keep rates high to garner deposits,
which also reduces their ability to cut lending rates. In addition, inflation
will inch back up to 4% level in 2HFY20, which implies that the window for
rate cuts remains limited.
With benign
inflation, growth concerns come to the fore: Lower-than-expected inflation,
concerns over sluggishness in domestic growth, and slowing global growth
aided the RBI’s decision for a rate cut. The central bank has revised
downwards its inflation forecast for 4QFY19 to 2.8% from 2.7%-3.2% for 2HFY19
earlier.
The inflation forecast for 1HFY20 has also been lowered to 3.2%-3.4%
from 3.8%-4.2% earlier. Our forecasts are lower at 2.6% for 4QFY19 and 3.1%
for 1HFY20. Our forecast for 3QFY20 at 4.0% is a tad higher than the RBI’s
3.9%. Moreover, 3-month ahead inflation expectations have softened by 80bps,
while it has softened by 130bps for the 12-month ahead period.
As RBI
Governor Mr. Shaktikanta Das put it, the change in stance to neutral provides
flexibility to address concerns over sustained growth, as long as inflation
remains benign. GDP growth for FY19 is pegged at 7.2% by the CSO compared
with the RBI’s earlier forecast of 7.4%, while the RBI’s forecast for FY20
stands at 7.4%. Our numbers for FY19 and FY20 stand at 7.2% and 7%,
respectively. The MPC statement noted that the output gap has opened up modestly
as actual output inched lower than its potential.
Investment activity is
recovering, but supported mainly by public spending on infrastructure. The
need is to strengthen private investment activity and buttress private
consumption.
One more rate cut
likely, but see limited room for sustained easing: With a 25bps rate
cut, we see room for another 25bps rate cut in 1QFY20 (mostly in April 2019)
with inflation likely to remain muted in 1HFY20. The RBI also stated that
headline inflation is likely to remain soft in the near term, reflecting the
current low level of inflation and the benign food inflation outlook. The RBI
does not see near-term risks to inflation from the interim Union budget for
2019-20 proposals to boost farm income. The MPC statement noted that several
proposals in the interim budget are likely to boost aggregate demand by
increasing disposable income, but the full effect of some of the measures is
likely to materialise over a period of time. In addition, as we had pointed
out in our earlier report: Inflation:
A New Normal?, benign food inflation
generally tends to pull down inflation expectations (Exhibit 2). The upside
risk to inflation beyond the near term mainly stems from possibility of a
spike in vegetable prices, uncertainty around crude oil price and
monsoon-related uncertainty. Monsoon-related uncertainty may weigh on the
policy at the MPC’s June 2019 meeting, and consequently we see high
probability of a rate cut in April 2019 rather than in June. However, in our
view, the scope for sustained rate cuts may be curtailed by lower
transmission capability on the part of banks. With the credit-to-deposit
ratio at around 77.8% (Exhibit 3), banks will have to keep rates high to
garner deposits, which also reduces their ability to cut lending rates. In
addition, inflation will inch back to the 4% level in 2HFY20, which implies
that the window for rate cuts remains limited.
Core inflation
will soften, but may not fall below 5%: The RBI noted that the recent unusual
pick-up in the prices of healthcare and education could be a one-off
phenomenon, but it must be closely watched. We expect core inflation to
soften, but not beyond 5% level. In post-reform India, core inflation has
never really fallen below 5% (Exhibit 4), which in our view, limits the
ability to cut real rates drastically. The RBI reiterated that it does not
target any particular level of real rates, but Dr. Viral Acharya pointed out
that it is more appropriate to measure real rates with respect to core
inflation, which implies that even with the repo rate at 6% and core CPI
around 5%, the real rate will be at a comfortable 1%, although it will be
higher when compared against headline inflation.
Regulatory easing
supportive: In other positive developments, the 20% exposure limit to a single
corporate entity for foreign portfolio investment in corporate bonds will be
relaxed. This is likely to help revive flows into the corporate bond market.
Bank lending to NBFCs will be permitted to be risk-weighted based on their
assigned ratings (as is the case with other corporates), in contrast to the
100% risk weight applied currently. This move is likely to encourage bank
lending to NBFCs, while easing borrowing costs for NBFCs at the margin.
Resolution applicants under the Corporate Insolvency Resolution Process will
also be allowed to avail of External Commercial Borrowing (ECB) to repay
existing lenders. The collateral-free lending limit for agriculture has been
increased to Rs160,000 from Rs100,000 earlier, which is positive for consumption.
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