Macro backdrop calls for status quo on rates

The macroeconomic backdrop for the December Monetary Policy Committee (MPC) meeting is one of recovery gaining traction from a recession, on one hand, and CPI inflation holding well above the upper-end of the target band of 6 per cent for five consecutive months, on the other.

Official estimates of the second quarter gross domestic product (GDP) showed that in a multi-speed recovery, manufacturing sector helped both by improving domestic trade and external demand is normalising, even as farm sector continues to show positive growth, while services sector is lagging. PMI data for the current quarter shows that manufacturing sector activity picked up sequentially, while private services, came out of contraction. Farm sector prospects also look better this year on a normal monsoon.

However, a confluence of factors – supply disruptions, erratic monsoons induced food price spikes, higher taxes on fuel and intoxicants, along with high precious metal prices – have led to headline inflation rising faster than anticipated. This setting, thus, calls for status quo on rates to be extended and a reassessment of the growth and inflation outlook, given the high degree of uncertainty associated with any GDP growth estimate at this stage.

The MPC in all likelihood would keep the repo rate unchanged at 4 per cent, extending the pause from its August and October meetings and reiterating the accommodative stance. There is a risk of food inflation becoming more generalised and dragging already weak consumption lower. The MPC members flagged that in the October meeting and will be carefully monitoring this spillover. Moreover, a better-than-expected growth outturn would provide time for the MPC to see through transient food price pressures and assess the underlying inflationary conditions beyond November, as food prices seasonally witness easing from December. 

The scope for repo rate easing is limited to 25-50 basis points (bps) and any further easing may now only happen in the next fiscal year. Headline CPI inflation could ease gradually towards the 4 per cent target over the next four quarters, on the back of easing food inflation and protracted recovery in consumption, after the pent-up demand is met. Real GDP growth should pick up, too, with a positive headline print likely in the current quarter. But, in all likelihood the March 2019 level of GDP may only be achieved in March 2022. That in turn would keep the output gap negative and keep demand side pressures on inflation in check. Thus, lower food inflation and below potential GDP would open up space for further monetary policy easing in April or June 2021.  

In terms of the forward guidance, the MPC has already made it clear that it would maintain an accommodative stance for this year and for most of next fiscal year, in order to aid normalisation of economic activity from this year and to ensure a meaningful recovery in the next. That implies that policy rates will remain lower for longer, even though any further easing may be limited in magnitude. The focus of the Reserve Bank of India (RBI) in the meantime will remain on improving transmission of past policy signals through banking, sovereign bonds and credit market channels. The aim of RBI is to ensure that lower policy rates are reflected in lower cost of borrowings for the Centre, states and the corporate sector. Through its open market bond purchases, for both central and state governments, RBI will continue to reduce the cost of borrowings for the general government. The central bank may also provide some guidance on the withdrawal of liquidity, with durable surplus now touching Rs 8 trillion.

(The author is the chief economist of IndusInd Bank. Views are personal)