It is always a challenge for an inflation targeting emerging market central bank to balance growth objectives with a primary inflation mandate. India’s monetary policy committee also finds itself facing a similar dilemma going into the meeting on December 5. Inflation prints have started inching up sharply of late and are likely to stay above the 5 percent level for at least three months ahead. Along with that, we have seen GDP prints in Q2 FY2020 which are at record lows from a nominal GDP perspective. Notwithstanding the same, in our view, the MPC’s path ahead should be clear.
In the last meeting, for the first time, the committee had introduced forward guidance which linked future action to growth objectives. Private demand growth in the Q2 GDP was a mere 3.1 percent YoY which suggests that the government did most of the heavy lifting. Even though statistically the headline growth prints could trend upwards from hereon, a true bottoming out as far as high-frequency indicators are concerned is probably still some time away. The sharp drop in investment demand and the continued weakness in consumption proxies such as trade, hotels, transport, etc. are particularly worrying. The slight pickup in the growth rate of private final consumption expenditure in our opinion could be more statistical rather than indicative of actual on-ground consumption trends.
Against this backdrop, the discussion would not be about whether there will be further accommodation on December 5 but rather about what else can be done to bolster the dovish message. Growth prospects have been slowing for a while now and our own GDP forecast for FY2020 is about 5.1 percent YoY. Hence we believe that the probability of a larger quantum of cut (up to 40 bps) has risen even as a more calibrated response of 25 bps may seem more likely. The quantum of cut might not be as important as strong forward guidance, which will help to allay concerns on primarily three fronts.
Inflation is still the primary mandate
Firstly, even though we agree that the current demand slowdown requires decisive action but inflation is still the primary mandate and a spike in CPI far in excess of RBI’s projected path should temper the quantum of easing. Our own projections for CPI not only for this fiscal year but also for the next is significantly higher than what the RBI is currently expecting. Several factors will keep CPI elevated in the short term including food prices and also some possible temporary spikes in core CPI on account of the recent telecom tariff hikes.
Secondly, in the last policy meeting, the committee members especially the governor were more sanguine about the fiscal deficit target for the year. At this point in time, it is seemingly obvious that there will be a breach in the fiscal deficit target and there would be some need for extra borrowing by the government as well.
Thirdly, we believe that at this juncture just the magnitude of the repo rate cut probably has limited incremental efficacy to revive aggregate demand in the economy. The main channel through which this will work would be through lending rates and into the broader real economy. Among other things, the process of transmission would happen in a more robust manner if there was conviction that the cycle would stay accommodative for longer.
All of this can be achieved through a well-crafted forward guidance, which could give explicit growth targets and explain the need to look through the spikes in inflation and the breach in fiscal deficit in order to support growth and give firm assurance that interest rates will stay “lower for longer.”
More effective transmission in bank rates would also require other steps to reduce rates on competing avenues for financial savings and to restore some modicum of confidence in the financial system especially in that of the shadow banking industry. Some government measures taken already are working towards this end and it has been seen in tightening credit spreads for at least the relatively higher-rated credit papers. The expectation of fiscal slippages and higher borrowing affecting transmission into market rates can be offset somewhat by various means including bilateral switches between the RBI and the government or even conducting an open market purchase of bonds even though there is no immediate liquidity imperative.
Given the current growth conditions and the fact that we expect FY21 growth to pick up only moderately, we continue to expect another rate cut in this fiscal year. The steepness in the yield curve is at a multiyear high. It may continue in the short term given the concerns about higher borrowings even as accommodative monetary policy and ample liquidity anchor the short end. We expect the curve to bull steepen from the current level.
B Prasanna is Head - Global Markets Group at ICICI Bank.