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View: RBI policy: Emphasis on guidance as interest rates on hold

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RBI’s own assessment released this month now projects GDP growth to now contract by (-) 8.6 percent in Q2FY21 compared with a reduction of (-) 9.8 percent projected almost two months ago.

View: RBI policy: Emphasis on guidance as interest rates on hold
The Reserve bank of India's (RBI) next Monetary Policy Committee (MPC) meeting is scheduled on December 2-4, 2020. While only two months have passed since the last meeting, the economy has definitely shifted gears. RBI’s own assessment released this month now projects GDP growth to now contract by (-) 8.6 percent in Q2FY21 compared with a reduction of (-) 9.8 percent projected almost two months ago.
What is driving upward revision in growth estimates? For one, there was pent up demand, which had to be met once the economy was unlocked. Second, exports rebounded sharply as global supply chains and global economy saw a sharp reversal. Third, rural economy remains resilient and consumer demand shifted to goods from services. Last but not the least, fiscal and monetary stimulus to the tune of 15 percent of GDP has also worked in ensuring a quick turnaround in the economy.
Corporate India is echoing a similar sentiment. With cost control and optimization of supply chains, corporate India has been able to withstand the COVID-19 economic shock. Consumer FMCG, durables and vehicle manufacturers reported uptick in sales and sentiment during the previous quarter and the festive period.
However, the economy is yet to fully recover, in particular the informal economy. One of the indicators of demand from the informal economy is two-wheeler sales. While two-wheeler dispatches from factories are up by 17 percent, retail sales have been relatively lower. Urban India, in particular, metro cities have been impacted most by the pandemic.
Improvement in the informal economy is contingent upon a reduction in COVID-19 cases. Some state governments are looking at imposing restrictions as the infection rate is increasing over the last few days.
Ideally, the backdrop calls for further reduction in rates, which is what Indonesia did last week. However, the retail inflation rate in India is more than 600 bps higher than in Indonesia. In fact, the inflation rate in Emerging Markets (EM) has fallen by 1.2 percent since December 2019 to 2.8 percent in September 2020. On the other hand, the inflation rate in India has averaged 6.8 percent in CYTD20.
The increase in inflation is driven by higher food prices, an increase in duties on petrol and diesel and higher gold prices. Out of 12 categories within the food, as many as 6 items have inflation above 10 percent. Apart from vegetables, protein-based items such as pulses and eggs are also witnessing higher inflation. While some of the increase is due to unseasonal rains and an increase in logistics costs, some of the increase can also be explained by a higher demand for currency (correlation of 0.66 with food inflation).
While core inflation is also elevated at 5.9 percent, a large part of it is driven by higher retail prices of petroleum products and gold prices. A demand centric core inflation metric shows core (demand) inflation is much lower at 3.5 percent. This indicator is likely to go up only once economic activity normalizes.
However, MPC cannot ignore overall inflation and its generalisation into wages for agriculture labour and non-agriculture labour seen in the latest data. Thus, the best way for MPC to move forward would be to continue with the policy rate at the current level.
In the last meeting, MPC had communicated forward guidance of maintaining accommodative monetary stance and liquidity conditions well into next financial year. The communication helped in anchoring market expectations on liquidity. The system-level durable liquidity surplus continues to be large due to RBI's OMOs of Rs 2.8 trillion (including operation twist) in the year and FX intervention of  $73.6 billion.
The large surplus along with OMOs for state government securities has led to a benign interest rate environment for a large number of borrowers. For instance, the spread charged to AAA corporate borrowers over 3-year sovereign credit has fallen to 22 bps now compared with 113 bps in March 2020.
Thus, RBI's intervention has helped in ensuring a stable financing environment. This is true not only for India but large parts of the world. For instance, the yield on non-investment grade bonds in the US has fallen to 4.7 percent from 11.7 percent in March 2020. US housing market, too, is showing an increase in activity and construction due to lower rates and requirement of larger homes during the pandemic.
The low rate environment and accommodative monetary conditions along with higher demand for manufacturing products have led to sustained increase in global commodity prices (CRB index is up by 10.2 percent YoY), equity markets (Dow is +6.4 percent), precious metals (gold is up by 27.3 percent) and agriculture commodities (+13.1 percent).
Needless to say, this will put further pressure on domestic inflation. Global liquidity conditions may remain accommodative. MPC will have to navigate the global backdrop and ensure the inflation remains at its target of 4 percent while ensuring sustained increase in growth. The next MPC meeting could reiterate the past guidance while being mindful of risks.
The author is Chief Economist at Bank of Baroda
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