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India's monetary policy cycle: How close are we to the terminal repo rate?


While the rate cut in August will be highly dependent on the realised outcomes of food and fuel, we also concede that the window of a rate cut is narrowing

India's monetary policy cycle: How close are we to the terminal repo rate?
The Monetary Policy Committee (MPC) minutes released last week provide a rationale for the second rate cut in April after the one administered in February. The decision hinged on weakening domestic and global growth impulses, even while the headline CPI inflation is expected to remain benign over the fiscal.
However, the mandate was fractured with a 4:2 voting on interest rates (Chetan Ghate and Viral Acharya voted for a hold) and a 5:1 voting on stance (Ravindra Dholakia voted for a change of stance to accommodation). The composition of a non-consensus mandate requires a deeper dive into the minutes, to understand the course that the MPC could undertake not only over the next couple of policies but also the outlook over the medium term.
One of the key reasons for the twin rate cuts has been weakening domestic growth. Consumption indicators for both urban and rural economies have been faltering, with low food prices impeding rural activity. Moreover, despite higher than average capacity utilisation trends and robust growth in steel and cement sectors, industrial production has weakened and is expected to weaken further as consumption remains sluggish and investors wait for the outcome of the Lok Sabha elections. Global growth slowdown could also lead to headwinds to domestic growth.
On the other hand, inflation has remained well under the Reserve Bank of India’s 4 percent inflation target, driven primarily by low food prices, while fuel prices remained under control (until the April 2019 policy). Global externalities have also remained conducive with leading central banks pivoting towards accommodation over the past few months. This probably gave the MPC ammunition to cut repo rates by 50 bps since the beginning of this calendar year.  The fractured mandate, however, highlighted the discomfort of the two dissenters on sticky core inflation, expectations of sharp reversal of food prices, volatile oil prices and the belief that the slowdown in domestic growth is transient and is poised for recovery.
While the above reasons led the MPC to cut rates, future course of monetary policy in the very short term (the next two policies) would be determined by the realized outcomes of volatile components of food and international crude prices (even while core inflation moderates further), given that growth impulses will continue to remain weak over this time period.
Food prices have started to edge upwards and are expected to continue the upward momentum with the onset of summer months. The South-west monsoons will remain a wildcard and will play a dominant role in the members’ minds, with the second forecast due in the first week of June. International crude prices have also started to threaten the inflation outlook, with Brent crude touching highs seen last in November 2018.  Upside risks to oil prices underscored by supply-side concerns are expected to continue until the end of June, after which it is expected to ease, bringing down prices to more comfortable levels. These moving parts will probably lead the MPC to stay on hold in the June meeting (unless incoming data surprises to the downside).
Given these factors, there is a higher probability of a rate cut in August, by when there would be more clarity on the food and fuel trajectory. While the rate cut in August will be highly dependent on the realised outcomes of food and fuel, we also concede that the window of a rate cut is narrowing, especially given that our own inflation projections are ~50 bps higher than MPC’s projections for the second half of the fiscal. If the MPC were to cut rates in August, the structure of the vote would perhaps remain similar to the last two policies, unless headline inflation surprises excessively to the downside, in which case the mandate could shift to a 5-1 towards accommodation. The dissenting votes, in this case, could be based more on medium-term ideologies of the right level of the repo rate to maintain a 4 percent inflation in the medium term on a durable basis and structure of better transmission of monetary policy to the real economy.
This also brings forth the question of the committee’s monetary policy outlook in the medium term. Inflation is expected to average ~4 percent until FY2021.  Moreover, there are expectations of some revival in growth in the second half of the current fiscal, driven through a recovery in investment, as policy certainty assuages concerns. Expectations of better transmission of the ongoing monetary policy easing cycle to the real economy, than seen until now, could also help revive demand and private investment. The ongoing front loaded monetary policy stimulus by global central banks, could bolster global growth from its current doldrums towards the end of this year.
With these tailwinds to both domestic and global growth and expectations of a stable inflation outlook, we are probably edging closer towards the end of current monetary policy easing cycle, post the expected accommodation in the near term.
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