The RBI Monetary Policy announced on December 05th took the financial market by surprise as the RBI opted to keep status quo on repo rates. The markets were expecting a rate cut of 25 bps. While the RBI did maintain its stance as accommodative, there was consensus among the six MPC members to hold repo rates at 5.15%. What was more interesting was that the MPC included inflation as a key criterion for the future direction of rates. In the last few policy statements, the MPC had purely focused only on the aspect of boosting GDP growth. That is the big change!
Why inflation is a worry?
According to the RBI policy statement, the inflation expectations have become very elevated. The sharp rise in inflation in the month of October to 4.6% was largely due to the spike in food inflation. In fact, food inflation at 6.9% was at a 39-month high. The Kharif output had been good but the unseasonal rains in the months of September and October had caused tremendous damage to food crops resulting in a spike in food prices. That was best exhibited by the sharp 7-fold spike in onion prices. The RBI does not see the food inflation coming down any time soon and the status quo on rates was essentially a defence against future rise in food prices. With the OPEC likely to deepen supply cuts, RBI expects the fuel inflation also to spike. That was likely to keep the headline CPI inflation at an elevated level.
Concern over real rates
One of the factors that determine the attractiveness of Indian bonds for global investors is the real interest rates (interest yield net of inflation). As of 2018, the real yield was close to 4%. That was an attractive level to entice foreign investors to invest in Indian debt paper. Over the last 1 year, RBI has cut rates by 135 bps and the inflation is up by over 200 bps. This has resulted in the real rates becoming as low as 0.55%. That partially explains why the FPIs had turned net sellers in debt in November 2019. Another rate cut by the RBI would have exposed the real rates to the risk of turning negative, should inflation spike further from current levels. That was one of the key reasons for maintaining status quo on rates.
Room for fiscal boost
The RBI also gave an indication that rate cuts alone would not be enough to boost growth. Fiscal measures like cuts in personal tax rates, corporate tax rate cut, incentives for new manufacturing etc have already been announced. The full impact of these measures would only be visible in the next two quarters. Also, the Union Budget will be presented before the next policy and that could give a better fiscal framework for the RBI to decide on rates trajectory. It is important to note that repo rates are already at the lowest levels since 2003. That surely limits further cuts! ©