Contrary to market expectation of a status quo, the Reserve Bank of Indias Monetary Policy Committee reduced its benchmark repo rate by 25 bps to 6.25% at its sixth bi-monthly policy review today. As such, the reverse repo rate and the MSF rate now stand adjusted at 6.00%, and 6.50% respectively. Four out of six MPC members voted for the rate cut, with the other two voting to keep the policy rate unchanged. The rate cut decision was accompanied by a shift in monetary policy stance to ‘neutral from ‘calibrated tightening earlier. This was not only on expected lines by market consensus, but also a unanimous thought process within the MPC.

Key takeaways

Inflation: The central bank lowered its CPI inflation trajectory to 2.8% in Q4 FY19 and 3.2-3.4% in H1 FY20 vis-à-vis its earlier projection of 2.7-3.2% in H2 FY19 and 3.8-4.2% in H1 FY20. It also introduced its CPI inflation forecast for Q3 FY20, which is pegged at 3.9%. Unlike the Dec-18 policy review where risks to forecasts were estimated to lie on the upside, the RBI now expects the balance of risk to be neutral.

Growth: The central bank introduced its FY20 GDP growth forecast at 7.4% (with risks evenly balanced), up from CSO's estimate of 7.2% in FY19.

MPC Voting: While the MPC was unanimous in voting for the shift in monetary policy stance, there was divergence in the voting pattern. A 4-2 voting outcome is the first in the history of RBI's MPC. The emerging difference in opinion is likely to be evaluated closely by market participants to assess future policy cues.

Rationale for forecasts

• The downward revision to the CPI inflation trajectory primarily reflects the "unprecedented soft inflation recorded across food sub-groups". This is along expected lines as India's food inflation has been persistently surprising on the downside in recent quarters (for details, see - December CPI inflation: Sliding momentum on food and fuel, Jan 14, 2019). In addition, the crude oil price has been more or less stable while few items within domestic fuel (like electricity and firewood and chips) have turned soft.

• On growth front, the policy document does not provide any rationale for the expected improvement in FY20. It is also somewhat difficult to comprehend that while the central bank expects forecast risks on GDP growth to be evenly balanced, it at the same time lists out factors that are not yet supportive of upholding a higher momentum (like lack of broad based nature of overall financial flows in the country and slowing global growth).

The analysis

If one were to zoom out, it becomes evident that CPI inflation in India has been undershooting its mandated target on a trend basis. With average CPI inflation of 3.6% in FY18, the implied average CPI inflation in FY19 comes around 3.5-3.6%. Further, for FY20, the implied forecast average CPI inflation currently tracks 3.6-3.8% (assuming a close to 4% inflation outturn for Q4 FY20).

If one were to zoom in, then what comes out is the observation that after remaining below the 4% target in Q2 and Q3 of FY19, the RBI projects headline inflation to remain sub 4% in each of the next four quarters, i.e., until Q3 FY20. With the Governor reiterating the statutory mandate of targeting 4% inflation (with a band of +/- 2%), such a benign outcome along with the projected outlook indeed provided room for the central bank to eke out a dose of monetary accommodation.

Factors such as a sizeable correction in inflation expectation of households and producers, re-opening of the negative output gap (likely after the Q2 FY19 GDP data along with the outlook for H2 FY19), and relatively dovish commentary from the US Fed and the ECB further supported the decision to reverse the course of monetary policy.

Going forward, the future course of monetary policy trajectory would depend upon the following:

• The central bank expects overall food inflation to remain benign in the near term. While the annualized food inflation could remain benign in the near term, the momentum could see a buildup in the coming months. For the month of Jan-19, high frequency mandi prices are indicating 1.0% MoM jump in vegetable prices. This is much higher than the 15.6% and 12.1% MoM contraction seen in Dec-18 and Jan-18 respectively.

• Oil price "outlook continues to be hazy". We couldn't agree more on this as crude oil price has seen heightened volatility in the last one year amidst heavy geopolitical intervention. The futures market currently expects oil prices to end 2019 at an average price of USD 62.5, which is almost the same as the prevailing spot price. If oil price were to pan out along these lines, then there can be favorable impact on monthly FY20 inflation prints via statistical base effects.

• The FY19 and FY20 Union Budget has upped the share of revenue expenditure, which we reckon would help in boosting private consumption (for details, see - FY20 Interim Budget: Win Some, Lose Some, Feb 1, 2019). While this could transpire into higher pressure on demand led inflation, the impact is "likely to materialize over a period of time". Keeping in mind the implementation lags and its trickle down effect, such an outcome is quite likely. However, we believe the central bank would need to be extremely vigilant in this case as few items within core inflation (like health and education) have already started exhibiting unusual upward price pressures.

Assuming India Crude Basket to average close to USD 65 pb in FY20, we expect average CPI inflation to edge towards 4.1% in FY20 from an average of 3.7% in FY19. This calls for a prolonged pause in monetary policy with the likelihood of a moderate improvement in GDP growth momentum in the backdrop of a consumption led fiscal stimulus.

However, we note that forecasting domestic food and global crude oil prices is fraught with extreme challenges. If the recent softness in price of these commodities were to persist in the coming quarters, then there can be a likelihood of extending the sub 4% inflation trajectory beyond Q3 FY20. Such a scenario (which would be clearer with the next update of RBI's bi-annual Monetary Policy Report) could then potentially open up space for incremental monetary accommodation, as early as Apr-19.