RBI Hikes Rates, Notes Strength In Economic Activity

On the basis of an assessment of the current and evolving macroeconomic situation, the Monetary Policy Committee (MPC) of the Reserve Bank Of India (RBI) decided to increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points to 6.5%. Consequently, the reverse repo rate under the LAF stands adjusted to 6.25%, and the marginal standing facility (MSF) rate and the Bank Rate to 6.75%. The decision of the MPC is consistent with the neutral stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%, while supporting growth.

Industrial growth, measured by the index of industrial production (IIP), strengthened in April-May 2018 on a y-o-y basis. This was driven mainly by a significant turnaround in the production of capital goods and consumer durables. Growth in the infrastructure/construction sector accelerated sharply, reflecting the government's thrust on national highways and rural housing, while the growth of consumer non-durables decelerated significantly. The output of eight core industries accelerated in June due to higher production in petroleum refinery products, steel, coal and cement.

Capacity utilisation in the manufacturing sector remains robust. The assessment based on the Reserve Bank's business expectations index (BEI) for Q1:2018-19 remained optimistic notwithstanding some softening in production, order books and exports. The July manufacturing PMI remained in expansion zone, although it eased from its level a month ago with slower growth in output, new orders and employment.

Several high-frequency indicators of services activity increased at a faster pace in May-June. Tractor and two-wheeler sales growth accelerated significantly, suggesting strong rural demand. Passenger vehicle sales growth, an indicator of urban demand, also strengthened. Commercial vehicle sales growth remained robust despite some deceleration. Domestic air passenger traffic - another indicator of urban demand - maintained double-digit growth.

Construction activity indicators also improved with cement production sustaining double digit growth for the eighth consecutive month in June. Steel consumption also accelerated in May. The services PMI expanded to a twelve-month high in June, after a marginal contraction in May, supported by expansion in new business and employment.

Retail inflation, measured by the year-on-year change in the CPI, rose from 4.9% in May to 5% in June, driven by an uptick in inflation in fuel and in items other than food and fuel even as food inflation remained muted due to lower than usual seasonal uptick in prices of fruits and vegetables in summer months. Adjusting for the estimated impact of the 7th central pay commission's house rent allowances (HRA), headline inflation increased from 4.5% in May to 4.6% in June. Low inflation continued in cereals, meat, milk, oil, spices and non-alcoholic beverages, and pulses and sugar prices remained in deflation.

Turning to the growth outlook, various indicators suggest that economic activity has continued to be strong, noted the RBI. The progress of the monsoon so far and a sharper than the usual increase in MSPs of kharif crops are expected to boost rural demand by raising farmers' income. Robust corporate earnings, especially of fast moving consumer goods (FMCG) companies, also reflect buoyant rural demand. Investment activity remains firm even as there has been some tightening of financing conditions in the recent period.

Increased FDI flows in recent months and continued buoyant domestic capital market conditions bode well for investment activity. The activity in the manufacturing sector is expected to remain robust in Q2, though there may be some moderation in pace. Rising trade tensions may, however, have an adverse impact on India's exports. Based on an overall assessment, GDP growth projection for 2018-19 is retained, as in the June statement, at 7.4%, ranging 7.5-7.6% in H1 and 7.3-7.4% in H2, with risks evenly balanced; GDP growth for Q1:2019-20 is projected at 7.5%.

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