RBI stays firm on pause button: Rate reduction likely in August

After a series of surprising policy outcomes since December, the latest monetary policy committee (MPC) decision to keep rates unchanged with a dovish undertone to its statement cheered the market. The benchmark 10-year bond yields declined seven basis points (bps), while the 5-year overnight index swap (OIS) rate declined by 10 bps.
 

For us there were three takeaways. First, we believe that the MPC is likely to reduce policy rates by 25 bps to six per cent in the August policy meeting, as consumer price index (CPI)-based inflation is likely to remain subdued. In our view, FY18 CPI-based inflation is likely to average four per cent, hitting the MPC’s preferred medium-term target.

The MPC decision to adopt a wait-and-watch stance on Wednesday is based on sound factors — it wants greater visibility on the monsoon performance, on the government’s decision on house rent allowances, and on the sustainability of recent price declines. We think reassuring outcomes on most of these are likely to emerge by August, creating space for easing.  Such a move would increase the credibility of the inflation-targeting monetary policy framework, in our view.

Second, moving beyond the debate surrounding the remaining 25-50 bps reduction in the repo rate, Wednesday’s decision restored credibility around the MPC’s CPI projection. Over the past six months, deviations between MPC’s projection and actual prints have been 100 bps. With CPI as the most important determinant of the monetary policy decision, such deviations clouded visibility on the MPC’s reaction function.  The revisions in CPI were dramatic — from 4.75 per cent in April to between 2.75-4 per cent (derived by us based on the MPC’s semi-annual projections) in the June policy meeting.

However, the acknowledgement of the recent price declines, a good monsoon forecast, contained commodity prices and a stronger rupee was, in our view, a noteworthy course correction by the Reserve Bank of India (RBI).

Last but not the least, unlike the past four meetings, where all MPC members voted unanimously, the June policy meeting recorded the first dissenting vote. While the direction of dissention was not explicitly mentioned, it is likely that one member voted for a cut while the remaining five voted for a pause. In the last policy meeting, while one MPC member opined in favour of a rate hike, this never translated into a vote. This first dissent vote this time underlines that the MPC is evolving to the next stage of its development. Worries around MPC’s independence also likely reduced as the Governor stated that an invite for a monetary policy discussion from the finance ministry was declined by all MPC members.

Anubhuti Sahay - Head, South Asia Economic Research (India), Standard Chartered