MPC should go for rate cut of 15 bps
COMMENT
The upcoming Monetary Policy Committee (MPC) decision on December 5 could be one of the most challenging in 2019, if not in recent years. There are reasons for the MPC to take a breather, but it also could deliver more rate cuts amid weakening domestic growth.
The MPC has cumulatively cut repo rates by 135 basis points (bps) amid ample liquidity since February 2019, without pausing between the cuts. Given the current stabilisation in global sentiment on easing trade tensions, recent policy measures announced in India and slow transmission of rate cuts, the MPC has room to pause, alongside other central banks, to consider future plans.
Additionally, the recent spike in headline consumer price index (CPI) inflation much above the MPC’S comfort threshold of 4 per cent, in our view, could justify a ‘wait and watch’ approach among members. Headline CPI, after averaging
3 per cent during August 2018-September 2019, has moved higher on a spike in food prices. Adverse weather conditions and higher food prices are likely to push H2FY20 (April to September, 2019) CPI inflation to 4.7 per cent, in our view, much higher than the MPC’S mandated CPI threshold of 4 per cent.
While we believe the spike in inflation is likely to be temporary — the fading impact of adverse weather and arrival of fresh crops should lower food prices eventually, the MPC might like to wait for confirmation of this improvement. This is understandable, as some industries like steel are considering upward price revisions for their products, which could add to price pressures.
However, GDP (gross domestic product) growth reached a six-anda-half-year low of 4.5 per cent in
Q2FY20 (quarter ended September 2019). This leaves the MPC with a challenging backdrop. With H1FY20 GDP growth at 4.8 per cent, full-year FY20 GDP is unlikely to meet the MPC’S current projection of 6.1 per cent. In our view, FY20 GDP growth is likely to be 5.3 per cent. The MPC may have to recalibrate its GDP growth forecast lower by at least by 50-60 bps to factor in H1 weakness. A likely sharp downward revision in GDP growth and a marginal increase in its CPI projection (20-30 bps) contrasts with previous meetings, when both growth and inflation projections were revised in the same direction, facilitating rate decisions.
Nevertheless, we believe that the MPC can strike the right balance between rising inflation and weaker-than-expected GDP growth, by reducing the repo rate in the unconventional size of 15 bps to 5 per cent in December. This would be the second such unconventional rate cut — the MPC reduced the repo rate by 35 bps in August 2019. Such differently sized rate cuts were introduced and justified by Reserve Bank of India Governor Shaktikanta Das in 2019 to (1) better convey the policy stance, (2) avoid wasting ammunition just for the sake of rounding, and (3) avoid sharp policy divergence from forward guidance in a volatile global environment.
Besides the rate action, markets will closely watch for a split vote in favour of a cut versus a pause (if any). The last three rate cut actions featured a consensus among all six members, though a few advocated deeper rate cuts. The make-up of the vote will guide market expectations on future rate actions. We believe the MPC will pause after the December rate cut before it delivers another 25 bps cut in FY21. Its view on liquidity, especially for non-bank financial companies, will be also watched as uneven access to liquidity has made monetary policy transmission weaker than anticipated.