5 Factors that will drive the Policy Stance of Monetary Policy Committee

The RBI Monetary Policy Committee (MPC) will commence its 2-day meeting on 05th December which will conclude on 06th December. The outcome of the deliberations will be captured on December 07th in the form of the Monetary Policy. This policy becomes interesting in a variety of ways. Apart from the global circumstances under which this policy is being announced, the domestic liquidity shortfall will also be a significant factor.

5 key factors that will drive the monetary policy stance of the MPC…

  1. Inflation has been on the way down…

One of the key factors that will drive RBI will be the rate of inflation, especially the food inflation component of CPI. The CPI inflation has fallen sharply to 4.20% in the month of October and is likely to continue its downtrend in the month of November also. What is more critical is that the food inflation has come in at 3.39%, sharply, lower than the overall CPI inflation after a long time. That means the real drag on inflation is coming from non-food inflation. A mix of good monsoons, a better Kharif crop and a control over the supply side bottlenecks have helped food inflation to come down sharply. The CPI is well within the overall limits prescribed by the RBI in its previous policies and that will surely give room for the RBI to cut rates in this policy.

  1. Growth continues to be elusive…

The Core Sector growth for the month of October has come in higher at 6.6%, but that is not exactly translating into higher IIP growth. The reason is straightforward. The manufacturing sector, which forms the bulwark of the IIP, is struggling to grow. More importantly, the capital goods segment is still showing negative growth, which is bad news for the revival of the capital cycle. The bigger worry for the government could be the weakening GDP for the September quarter. GDP came in at 7.3% as against the market consensus of 7.5%. The GVA (which is GDP adjusted for indirect taxes) came in at just 7.1%. With the first half GDP growth coming in at just 7.2% annualized, the government’s original target of 7.6% surely looks very challenging. Large broking houses are already downgrading India’s growth to below 7% for the fiscal year 2016-17. Weak growth also makes a strong case for rate cut.

  1. Transmission is finally happening…

The transmission of rate cuts has started to improve as banks are now passing on rate cuts more seamlessly via the MCLR. The infusion of liquidity into the banking system to the tune of Rs.10,00,000 crore via demonetization is also helping transmission to the end customers. For long, the RBI was worried that rate cuts with transmission rates of below 50% was defeating the basic purpose of rate cuts. Better transmission also makes a very strong case for a rate cut in this policy.

  1. Demonetization could be the X-factor for the RBI…

A very important factor that will influence the MPC in their monetary stance will be the immediate impact of demonetization. The banking system has already impounded Rs.10,00,000 crore worth of old notes while the supply of fresh notes has failed to keep pace. This has created a major liquidity imbalance in the system which is manifesting in the form of production constraints, lower footfalls at outlets, slowdown in transactions etc. One of the ways the RBI may try to address this imbalance is through a rate cut. An aggressive rate cut of 25-50 bps may provide respite to the customers. It will, at least, coax banks to make funds available at lower cost. With the huge surge in CASA deposits, banks may actually be in a position to make funds available at lower rates. The RBI only needs to facilitate that through a repo rate signal. It could actually go a long way in addressing the temporary stress that industry is going through due to the demonetization exercise.

  1. What will the US Federal Reserve do?

Even as the MPC presents the monetary policy on December 07th, it will surely be weighed down by the fact that the US Federal Reserve will also be announcing its policy on December 14th. While the consensus is that the US Fed will increase rates by 25 basis points in its December Fed Policy, there is always an element of risk in the RBI second-guessing the Fed action. The spread between the US 10-year G-Sec and the Indian 10-year G-Sec has already shrunk by over 200 basis points in the last 3 months. This has been partially responsible for the surge in FII outflows from Debt of nearly $2.5 billion that we have seen in the month of November. This will, probably, be the trickiest call for the MPC to take.

The first four factors mentioned above, surely make a case for the MPC to go ahead and announce a rate cut of at least 25 basis points. But the US Fed action remains the big question. How the MPC views the US Fed rate action will eventually determine the MPC’s decision on repo rates in the December 07th monetary policy.

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