RBI monetary policy: The Indian central bank signals a prolonged pause

In an unanimous decision, the Reserve Bank of India (RBI) kept the repo rate unchanged in the 5 December policy, while continuing with the “calibrated tightening” monetary stance. Five monetary policy committee members voted in favour of the monetary stance remaining unchanged, while Ravindra Dholakia voted for a neutral stance, in line with his past decision.

The central bank decided to lower the statutory liquidity ratio (SLR) by 25 basis points over six quarters to 18 per cent starting January 2019.

The RBI lowered its inflation projection further to 2.7-3.2 per cent (from 3.9-4.5 per cent earlier) and to 3.8-4.2 per cent for the first half (H1) 2019-20 (versus earlier forecast of 4.8 per cent for April-June 2018-19, or FY19), while maintaining the growth projection for FY19 at 7.4 per cent. 

The sharp reduction in inflation forecast raises the possibility of the RBI changing its “calibrated tightening” monetary stance back to “neutral”, but we don’t expect the central bank to follow through with an outright rate cut, unless inflation starts printing materially lower than its downward revised projection. Given the latest inflation developments and guidance, we expect a prolonged pause from the RBI.

According to our current projection, the consumer price index (CPI)-based inflation rate should be about 4.2-4.3 per cent by end-September 2019, in line with the RBI’s forecast and then head toward 4.6-4.7 per cent by November-December 2019 because of a negative base effect. 

While the RBI can potentially change its monetary policy stance back to neutral, delivering a rate cut could be difficult with the CPI inflation rate heading over 4 per cent from the end of the third quarter (Q3) 2019. 

Also core inflation remains elevated, and even if there is some moderation in the months ahead, is unlikely to fall below 5 per cent and converge with the headline CPI, which the RBI targets. 

Further, growth momentum is expected to accelerate in FY20 compared to FY19 and bank credit growth has already started increasing (15 per cent year-on-year) above the nominal gross domestic product (GDP) growth rate (11.5-12 per cent according to our estimate).

Disinflation in certain food items, namely pulses, vegetables, and sugar have pushed down the CPI inflation trajectory to abnormally low levels, but excluding these few items, underlying inflation rate is well above the 5 per cent mark. 

A sudden reversal of the benign food price dynamic could therefore pose a risk to the medium term inflation outlook and inflation expectations of households, which the central bank needs to be cautious about before considering cutting rates.

Also, with domestic investment growth rate likely to increase over the next few years, the RBI will have to maintain a policy rate level which incentivizes incremental increase in domestic savings, in order to keep the current account deficit under check. 

Add to this, expectations of continued tightening from the US Federal Reserve and India’s need to attract foreign inflows into the country, the case for a rate cut does not seem obvious, in our view.

As far as liquidity management is concerned, the RBI has made it clear that it will prefer to continue with OMO purchases to push money market liquidity deficit toward neutrality and look to use CRR cut only under exceptionally tight liquidity conditions.

The writer is India Chief Economist, Deutsche Bank