4 Key Considerations ahead of the Monetary Policy Committee

As the Monetary Policy Committee (MPC) meets up ahead of the crucial monetary policy announcement on 07th December, the key question is whether there will be a rate cut or not? While the original expectation was that the rate cut will be put off due to the uncertainty over Fed rate trajectory, the impact of demonetization may have forced the RBI to modify its strategy. The RBI may look to give a fillip to domestic growth with a rate cut in the December policy. Here are the 4 key factors that will go into the MPC’s calculation while taking a decision on repo rates…

Thanks to food inflation, CPI is showing a downtrend…

If the October CPI numbers has re-affirmed anything, it is that inflation is headed firmly downward. Ironically, over the last 2 months non-food inflation is what is actually pushing CPI inflation higher as food inflation is now well below the CPI inflation mark. The sharp fall in food inflation by nearly 500 basis points over the last 4 months is indicative of a few key underlying trend shifts. Firstly, the normal monsoon this year after 2 successive years of drought has brought a degree of sanity to prices of cereals, pulses, fruits and vegetables in India. Secondly, the Kharif output is likely to be a bumper crop this time around as per early signals. That would go a long way in tempering inflation. Lastly, the government has successfully addressed supply side bottlenecks. With inflation headed downwards, the MPC has a clear case for a rate cut in this policy. The only consideration could be that the Rabi crop may be below target due to the impact of demonetization.

RBI needs to provide a big push to economic growth…

The growth numbers in the last couple of months have been fairly disappointing. While the IIP growth has been tepid, the core sector continues to put up a better show. This is paradoxical considering that the core sector accounts for nearly 38% of IIP. The big challenge for the government is giving a push to manufacturing. The problem today is insufficiency of demand. On the one hand industry is operating at a capacity utilization of around 70% and weak demand is worsening the problem. GDP for the September quarter has come in at 7.3% while the GVA (without considering the impact of indirect taxes) has come in at just 7.1%. This raises serious doubts over the government’s original targets of reaching 7.6% growth. In fact, Fitch India has projected GDP growth for 2016-17 growth to fall below the 6.9% mark. The demonetisation exercise has put a lot of deposits with the banks. The ideal strategy for the MPC could be to cut rates aggressively so that funds can be made available to industry at much lower rates. The tepid growth makes a very strong case for a rate cut in the December policy.

Addressing the demonetization pinch…

The big change since the last monetary policy announced in October has been the demonetization drive launched on 09th November. The pressure is visible in the PMI-Manufacturing and the PMI-Services for the month of November 2016. While the PMI-Manufacturing fell by just about 2 points, the PMI-Services fell by nearly 8 points into contraction zone. This is, perhaps, the clearest evidence that demonetization has started making its impact felt. What does this mean for the MPC? Firstly, this crunch is caused by the liquidity imbalance as the value of notes impounded is substantially larger than the value of fresh notes issued. Lower rates will make it easier for money to pass from banks to industry in a more seamless manner. At least as a temporary measure, the MPC may look at front ending the rate cut from February 2017 to December 2016 to compensate for the liquidity shortfall caused by demonetization.

Betting on the Fed rate announcement and trajectory…

While low inflation, weak growth and demonetization make a strong case for a rate cut, the only question mark could be the trajectory of the US Fed. A 25 basis points rate hike is already factored into markets. Remember, the US PMI for manufacturing and services have been extremely buoyant for the month of November. This may coax the Fed to also provide a hawkish stance with respect to interest rates. That could be the only worry for MPC. If the trajectory of the Fed is hawkish, then it will lead to further hardening of 10-year benchmark yields in the US. The gap between India’s 10-year benchmark and the US 10-year benchmark has narrowed by nearly 200 bps in the last few months. If the RBI is dovish and the Fed is hawkish, then this gap could narrow further and that may have serious implications for FII debt outflows. That is a situation the RBI may not be too comfortable having, especially when the rupee has already weakened beyond the 68/$ mark.

The MPC may have a tightrope to walk when it announces the credit policy on 07th December. The actual text of the deliberations will be a lot more interesting. It looks like the RBI may veer towards front-ending its Feb 2017 rate cut to December 2016. Demonetization may have made the difference!