RBI raise repo rate by 25 bps to 6.5%

CPI inflation projected at 4.8% for H2 of 2018-19, GDP growth forecast retained at 7.4% for 2018-19

The Monetary Policy Committee (MPC) of the Reserve Bank of India at its Third Bi-monthly Monetary Policy review announced on 01 August 2018 has raised the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points (bps) 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%.

Earlier, the RBI had raised repo rate by 25 bps on 06 June 2018 after a gap of four and half years.

Five out of six members of the MPC voted in favour of rate hike on 01 August 2018. 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. The main considerations underlying the decision are set out in the statement below.

In the second bi-monthly resolution of 2018-19, CPI inflation for 2018-19 was projected at 4.8-4.9% in H1 and 4.7% in H2, including the HRA impact for central government employees, with risks tilted to the upside. Excluding the impact of HRA revisions, CPI inflation was projected at 4.6% in H1 and 4.7% in H2. Actual inflation outcomes have been slightly below the projected trajectory as the seasonal summer surge in vegetable prices has remained somewhat muted in comparison with its past behaviour and fruits prices have declined.

The inflation outlook is likely to be shaped by several factors. First, the central government has decided to fix the minimum support prices (MSPs) of at least 150% of the cost of production for all kharif crops for the sowing season of 2018-19. This increase in MSPs for kharif crops, which is much larger than the average increase seen in the past few years, will have a direct impact on food inflation and second round effects on headline inflation. A part of the increase in MSPs based on historical trends was already included in the June baseline projections. As such, only the incremental increase in MSPs over the average increase in the past will impact inflation projections. However, there is a considerable uncertainty and the exact impact would depend on the nature and scale of the government's procurement operations. Second, the overall performance of the monsoon so far augurs well for food inflation in the medium-term. Third, crude oil prices have moderated slightly, but remain at elevated levels. Fourth, the central government has reduced Goods and Services Tax (GST) rates on several goods and services. This will have some direct moderating impact on inflation, provided there is a pass-through of reduced GST rates to retail consumers. Fifth, inflation in items excluding food and fuel has been broad-based and has risen significantly in recent months, reflecting greater pass-through of rising input costs and improving demand conditions. Finally, financial markets continue to be volatile.

Based on an assessment of the above-mentioned factors, inflation is projected at 4.6% in Q2, 4.8% in H2 of 2018-19 and 5.0% in Q1 of 2019-20, with risks evenly balanced. Excluding the HRA impact, CPI inflation is projected at 4.4% in Q2, 4.7-4.8% in H2 and 5.0% in Q1 of 2019-20.

Turning to the growth outlook, various indicators suggest that economic activity has continued to be strong. 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 Reserve Bank's IOS indicates that 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%.

Even as inflation projections for Q2 have been revised marginally downwards vis-vis the June statement, projections for Q3 onwards remain broadly unchanged. Several risks persist. First, crude oil prices continue to be volatile and vulnerable to both upside and downside risks. In particular, while geopolitical tensions and supply disruptions remain an upside risk to oil prices, the fall in global demand due to further intensification of protectionist trade policies could pull down oil prices. Second, volatility in global financial markets continues to impart uncertainty to the inflation outlook. Third, households' inflation expectations, as measured by the Reserve Bank's survey, have risen significantly in the last two rounds, which could influence actual inflation outcomes in the months to come. Fourth, manufacturing firms polled in the Reserve Bank's industrial outlook survey have reported hardening of input price pressures in Q2 of 2018-19. However, if the recent softening of global commodity prices persists, it could mitigate some of the upward pressure on input costs. Fifth, though the monsoon has been normal temporally so far, its regional distribution needs to be carefully monitored in the context of key CPI components such as paddy. Sixth, in case there is fiscal slippage at the centre and/or state levels, it could have adverse implications for market volatility, crowd out private investment and impact the outlook for inflation. Seventh, uncertainty around the full impact of MSP on inflation will only resolve in the next several months once the price support schemes are implemented. Finally, the staggered impact of HRA revision by state governments may push headline inflation up. While the statistical impact of HRA revisions will be looked through, there is need to watch out for any second-round impact on inflation.

Against the above backdrop, the MPC decided to increase the policy repo rate by 25 basis points. The MPC reiterates its commitment to achieving the medium-term target for headline inflation of 4% on a durable basis.

The MPC notes that domestic economic activity has continued to sustain momentum and the output gap has virtually closed. However, uncertainty around domestic inflation needs to be carefully monitored in the coming months. In addition, recent global developments raise some concerns. Rising trade protectionism poses a grave risk to near-term and long-term global growth prospects by adversely impacting investment, disrupting global supply chains and hampering productivity. Geopolitical tensions and elevated oil prices continue to be the other sources of risk to global growth.

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