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Posted by: Deepa Vasudevan on Thu, Dec 6th, 2018

A Supportive Monetary Policy

In the Fifth Bi-Monthly Monetary Policy Statement released on December 5, 2018, the Monetary Policy Committee voted to hold the key policy repo rate constant. Instead, the focus was on measures to ensure adequate liquidity, improve monetary transmission, and encourage banks to lend in a more transparent manner.

 

Pic 1: Key Interest Rates

 

This monetary policy comes at a time when the economy faces a rare combination of low inflation and fairly robust growth. During Apr-Oct 2018, retail inflation averaged 4.2%, well-within the mandated 4%-6% range.  Low prices of food and fuel have led to a significant downgrade of inflation forecasts- RBI now expects inflation to remain below 4% over the next one year. At the same time, growth is expected to be around 7.4% during FY19, supported by rising investment, strong bank credit, and stable consumption.

However, there are several risks to growth and inflation. Price pressures from non-food non-fuel items has ensured that headline inflation is low, but core inflation is much higher at around 6%. The impact of OPEC actions on crude prices is awaited, the effect of MSP increases on food prices is still unclear, and HRA increases by State Governments could have a staggered impact on demand and prices. These factors could potentially push up inflation much higher the current predictions. On the growth front, downside risks include the uncertain outcome of the US-China trade war, possible decline in rural demand, and higher financial market volatility. On the other hand, a recovery in bank credit and investment are likely to provide a strong impetus to growth, and government spending on roads and housing could pull in private investment into various sectors.

With various factors pulling growth and inflation in opposite directions, it made sense for the MPC to wait for more data before deciding to increase or decrease interest rates. Other announcements included laying out a plan of liquidity support through OMOs and reduction in Statutory Liquidity Ratio (SLR), and a promise to be a lender of last resort for NBFCs if necessary. Banks will be required to link all retail floating rate loans to an external benchmark rate rather than a bank-specific MCLR; this will ensure that rate changes by RBI are passed on faster to retail consumers as external benchmarks tend to be more sensitive to policy rates.  

Bond markets reacted positively to the policy. Yields fell across maturities; the benchmark 10-yr g-sec closed 8 basis points lower by end of day. The market sentiment is that rates will not be raised unless there is a sharp pick-up in inflation (say, due to an unexpected increase in crude prices).   Although the policy offered no monetary stimulus, the reassurance of liquidity support and the lower inflation forecasts were sufficient to boost debt markets.

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