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Explained: How to read RBI’s monetary policy review

Udit Misra
Most analysts expected RBI to cut repo rate (the rate at which RBI lends to the banking system) anywhere between 35 to 40 basis points. (PTI photo)

On Friday, Reserve Bank of India Governor Shaktikanta Das surprised markets by announcing both the RBI's revision of the benchmark interest rate in the economy as well as the economic growth outlook for the current financial year. Most analysts expected RBI to cut repo rate (the rate at which RBI lends to the banking system) anywhere between 35 to 40 basis points (a 100 basis points make up a single percentage point.) However, the RBI announced a cut of just 25 basis points. This was even more surprising considering that RBI has one of its sharpest revisions of economic growth. Within a matter of two months, that is since the last policy review in August, RBI has cut the GDP growth forecast from 6.9 per cent to just 6.1 per cent on Friday. The steep fall in expected growth is reflective of how surprised all the six members (three nominated by the government and three representing the RBI) of the Monetary Policy Committee have been by the slowdown in the economy.

Why has growth forecast been dialled down so sharply?

Partly it has to do with correcting the overestimation that was there in the last forecast. The GDP growth of just 5 per cent in the first quarter (April to June) of the current financial year has surprised the RBI. RBI Governor Das even went on record stating that. It was the fifth consecutive quarterly fall. What's more, private consumption, which is the biggest driver of economic growth in India by a huge margin, fell to an 18-quarter low. The months since have not shown much improvement. Thanks to a delayed start of the south-west monsoon, the first advance estimates for major Kharif crops are 0.8 per cent lower than the last year's estimates. Industrial activity, as measured by the index of industrial production has continued to weaken. From capacity utilisation to business assessment index all continue to slide. Capacity utilisation (CU) in the manufacturing sector, measured by the OBICUS (order books, inventory and capacity utilisation survey) of the Reserve Bank, declined to 73.6 per cent in Q1:2019-20 from 76.1 per cent in the previous quarter... Manufacturing firms polled for the industrial outlook survey (IOS) expect capacity utilisation to moderate in Q2:2019-20... The Reserve Bank s business assessment index (BAI) fell in Q2:2019-20 due to a decline in new orders, contraction in production, lower capacity utilisation and fall in profit margins of the surveyed firms, states the RBI report. High-frequency indicators suggest continued weakness in demand. As such, indicators of rural demand such as tractors and motorcycle sales have contracted. Similarly, sales of commercial vehicles contracted by double digits in July- August. Two key indicators of construction activity finished steel consumption and cement production either decelerated sharply or contracted. Clearly, the outlook for growth in Q2 (July to September) is not at all rosy. And that is why RBI has cut growth forecast sharply.

What is the growth outlook in the second half of the year and is it achievable?

The RBI expects the economy to grow by 5.3 per cent in Q2. But this assessment can be questioned considering that most indicators are pointing otherwise even by RBI's admission. For the second half of the year that is quarters 3 (Oct-Dec) and 4 (Jan-Mar) RBI expects the growth to range between 6.6-7.2 per cent. Again, as things stand, it is difficult to argue that growth will jump from 5.15 per cent (the average of H1 or the first half) to 6.6 per cent, leave alone 7.2 per cent. It is more likely that RBI revises the growth trajectory downwards yet again in the next couple of policy reviews.

If growth is so weak, why not cut rates more aggressively?

It is a valid question to ask. But one has to consider the roots of India's economic slowdown. If the slowdown was essentially because of the high cost of money holding back investment, then cutting interest rates makes a lot of sense. But that is not the case. The main problem with the economy is the collapse in consumption, which in turn has been due to a collapse in incomes and jobs. Yet, given the stage of India's economy and the fact that the government has just cut corporate tax rates, it makes sense to cut interest rates and incentivise new investments. But there are two more hurdles here. One is the issue of transmission of rate cuts. Of the 110 basis points of the repo rate cut, only 29 basis points were transmitted by the banking system to the final borrower. This weak transmission begs the question: whether it is wise to cut rates without first fixing the transmission. Two, and very importantly, is the issue of inflation. At present, most inflation indicators are well within RBI's comfort zone. But they are trending up. A good indicator of this is the behaviour of inflation expectations that people have and which are far more significant than actual inflation when framing monetary policy. The Reserve Bank s September 2019 round of inflation expectations survey indicates that households expect inflation to rise by 40 basis points over a 3-month ahead horizon and 20 basis points over a one-year ahead horizon, states the RBI report. This means people expect inflation to rise and RBI must not cut rates to such a level that it unleashes another monster that of high inflation.