Why the Decision of the MPC to Not Cut Rates was a Good Decision

The markets were largely disappointed by the decision of the Monetary Policy Committee (MPC) to maintain status quo on rates. The expectation was for a 25-50 bps cut in rates. However, the choice of the MPC not to cut rates was a good decision in retrospect. Here is why…

Upside risk to inflation…

Inflation at 4.20% for the month of October may be a bit misleading as there is a base impact. While food inflation appears to be under control, most items in the food basket, other than vegetables, are still vulnerable to supply shocks. The big risk for CPI inflation is non-food inflation as that is proving to be a lot stickier. Oil could be another risk to inflation. Brent has already rallied from $46/bbl to $54/bbl in a span of just 1 week. As Brent gets closer to $60, the impact of imported inflation could become very acute. Quite obviously, the RBI chose to err on the side of caution. The base effect on inflation typically wanes around the November-January period. That is when inflation has a tendency to trend higher. Cutting rates ahead of that may not have been an appropriate choice.

Rate cuts may not push growth…

In the minutes of the first MPC meet in October, most members were unanimous about front-loading a rate cut to spur growth. This was done despite upside risks to inflation. Over the last two months, the IIP growth has continued to be tepid and the RBI has already downgraded the full year Gross Value Added (GVA) from 7.6% to 7.1%. That is roughly $10 billion wiped out of annual output. With most industries still operating at around 65-70% capacity utilization, there is little scope for pushing IIP by making funds cheaper. Also, the demonetization has anyways put pressure on the liquidity in the system and any rate cuts are unlikely to be transmitted. Under these circumstances, a rate cut would have been little help in giving the much-needed boost to production.

Largely, it was about FII flows…

The real reason for the status quo may have been the uncertainty over the Fed stance on rates. The spread between the US 10-year bond yield and the Indian 10-year bond yield has narrowed by nearly 200 bps in the last few months. That was largely responsible for the $5 billion outflows in the month of November from equity and debt combined. A rate cut at this point of time would have only narrowed the gap further. More so, when the Fed is likely to hike rates and also adopt a hawkish tone. What the RBI has learnt from the 2013 crisis is that one can never take capital flows for granted. The trick lies in managing the spread at an attractive level. That lesson, probably, tipped the scale in favor of status quo. The MPC has prescribed the right dose!

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