MONETARY POLICY REVIEW - FEBRUARY 2018
RBI tone less hawkish than expected
As widely expected, RBI's Monetary Policy Committee (or MPC) maintained a status quo on policy rates. Consequently, the repo rate stands at 6%, the reverse repo rate at 5.75% and the Marginal Standing Facility (MSF) rate and Bank rate at 6.25%. Five members voted in favour of the monetary policy decision and one member voted for an increase in policy rates by 25bps. The MPC reiterated its commitment to keep headline inflation close to 4 per cent on a durable basis. Contrary to market expectations of a change in stance / tone to hawkish, it retained a neutral monetary policy stance.
For 2018-19, RBI estimates CPI inflation to be in the range of 5.1% to 5.6% in H1, including diminishing statistical HRA impact of central government employees and around 4.5% to 4.6% in H2, with risks tilted to the upside. RBI believes that the inflation outlook for next fiscal would be driven by various factors including international crude oil prices which have firmed up since August 2017 accompanied by an uptick in non-industrial raw material prices and monsoon, which has been assumed to be normal. The projected moderation in inflation in the second half is on account of strong favourable base effects (inflation rose quite sharply in Q3 2017), including unwinding of the 7th CPC's HRA impact, a softer food inflation forecast, given the assumption of normal monsoon and effective supply management by the Government.
The MPC also outlined several factors that make the inflation outlook quite uncertain on the upside. These include the staggered impact of HRA increases by various state governments pushing up headline inflation and potentially inducing second-round effects (i.e. inflation in other items due to HRA increases). A pick-up in global growth exerting further pressure on crude oil and commodity prices and the proposal in the Union Budget to revise guidelines for arriving at minimum support prices for kharif crops, although impact would be assessed once further details are available. Further, the increase in customs duty on a number of items and the fiscal slippage as indicated in the Union Budget could impact the inflation outlook. Besides, the normalization of monetary policy by major advanced economies could further adversely impact financing conditions (borrowing costs) and undermine the confidence of external investors (probably impacting the currency and thereby inflation).
They have also pointed out a few mitigating factors or factors that could have a downward impact on inflation. These include subdued capacity utilization (currently at around 71% to 72%), potential softening in crude oil prices based on production response and moderate rural real wage growth. Clearly the upside risks outweigh factors that could contribute to a downside in inflation.
In terms of its growth outlook, GVA growth for 2018-19 is projected at 7.2% overall – in the range of 7.3%-7.4% in H1 and 7.1%-7.2% in H2 with risks evenly balanced. The outlook would be influenced by several factors including stabilization of GST implementation which augurs well for growth, signs of revival in investment activity as reflected in improving credit offtake, large resource mobilization from the primary capital market, and improving capital goods production and imports. The process of recapitalization of public sector banks, which is underway and large distressed borrowers being referenced for resolution under the Insolvency and Bankruptcy Code (IBC) should help improve credit flows further and create demand for fresh investment. Export growth is expected to improve further on account of improving global demand, although elevated commodity prices may act as a drag.
Impact on the economy
RBI has been concerned about the inadequate transmission by banks of lower policy rates to borrowers, particularly existing ones. This has been due to the different methods used for calculation of lending rates by banks – namely the Marginal Cost of funds based lending rates (MCLR) and Base Rate (typically used for existing loans). Since MCLR is more sensitive to policy rate signals, the RBI has decided to harmonize the methodology of linking benchmark rates by linking the Base Rate to the MCLR with effect from April 1, 2018. This should help in better transmission of interest rates thereby benefitting the economy particularly when policy rates are being reduced.