The Reserve Bank of India left rates unchanged because, like us, it’s uncertain about a lot of things

  • On March 5th, the central bank decided to leave the repo rate unchanged at 6%.
  • The move highlights the RBI's uncertainty regarding the short-term trajectory of India’s economy.
  • The RBI has lowered its inflation guidance and forecasted a growth rate of 7.4% for fiscal 2019.

The first bi-monthly meeting of the Reserve Bank of India’s Monetary Policy Committee in the 2019 fiscal year turned out, as many expected, to be a non-event.

On March 5th, the six-member committee voted to keep the repo rate, or the rate at which it extends credit to commercial banks, unchanged at 6% for the fourth time in a row. The vote was 5-1.

The move underlines the fact that there are no easy answers when it comes to determining macroeconomic policy. The central bank has opted for a wait-and-watch approach in response to the lack of concrete data and trends. It is as uncertain about the short-term trajectory of India’s economy as we are. It does however, expect a slight decline in inflation and a pickup in economic growth- both of which justify its decision to stay the course on interest rates for the time being.

Central banks lower and raise interest rates for a number of reasons. In theory, if an economy is growing at a sluggish pace and/or inflation is too low, the central bank will reduce interest rates in order to stimulate investment and economic growth as companies will have lower borrowing costs. However, if the resultant pickup in growth leads to a higher-than-expected acceleration in prices, then the central bank will reduce interest rates to keep inflation in check.

However, in reality, this information can be hard to ascertain, especially in a country like India where official economic data can betray the ground reality due to the overwhelming size of the informal economy as well as failures in reporting and measurement. Acting hastily with respect to monetary policy can have far-reaching negative impacts across all sectors of the economy, which is why playing-it-safe is the guiding principle of central banks.

The RBI’s decision shows that its mainly uncertain about the following things:-

The looming spectre of higher inflation

The RBI surprised market analysts by lowering its inflation guidance, while retaining a cautious outlook on certain inflation risks. It expects inflation to fall between 4.7% and 5.1% in the first half of fiscal 2019, compared with a previous forecast of 5.1-5.6%. It expects a further decline in inflation to 4.4% in the second half, as against an original guidance of 4.5-4.6%. This is likely prompted by the fact that retail inflation fell for the second consecutive month this past February, to 4.4%, owing to a decline in vegetable prices.

However, there are a number of factors that could lead to a spike in inflation in the near term, all of which the RBI lacks clarity on. Firstly, if oil prices were to rise sharply, India, which imports four-fifths of its oil, would be adversely affected. Since crude oil prices are notoriously volatile, it can be hard to plan for a sharp increase. Secondly, a lower-than-expected rainfall in the coming monsoon will hurt food supplies and increase prices. Thirdly, the government’s revisions to the minimum support price scheme for kharif crops could also have an inflationary effect. Finally, the US Federal Reserve’s planned rate hikes this year could lead to an outflow of funds from India, which in turn, could lead to the depreciation of the rupee against the dollar, which in turn, will make imports more expensive.

Threats to India’s growth recovery


Like the IMF, the central bank also pegged GDP growth at 7.4% this year, compared to a growth rate of 6.6% in fiscal 2018. In the October-December period of 2017, India achieved its highest growth rate in five quarters, recording a growth of 7.2% following a rebound in manufacturing, agriculture and construction. Recent data on the increase in sales of two-wheelers ( an indicator of rural consumption), the expanding production of capital goods and higher demand for retail loans indicate a solid level of growth in the next few quarters.

But, as the RBI pointed out, there are a number of threats to this growth recovery. Firstly, the ongoing war over tariffs between US and China could lead to increased protectionism and hurt global growth. Secondly, the recent spate of frauds at India’s banks could result in a prolonged drag on private investment. It also remains to be seen how the government’s bank recapitalisation will pan out or whether the new bankruptcy rode will lead to the swift and effective resolution of insolvency cases. Finally, in anticipation of next year’s general elections, the government could be compelled to deviate from its budgeted expenditure by offering a number of handouts to vote banks which could hurt public finances and drive funds away from necessary investments like infrastructure and job creation.

Amidst all this uncertainty, the RBI is sure about one thing though.

The importance of making everyone feel good

Clearly, the RBI didn’t want to ruffle any feathers and hurt market sentiments with a rate hike. The central bank’s decision to lower its inflation guidance and reinforce the IMF’s bullish projections on India’s growth further indicate its desire to make everyone feel good and help facilitate a modest recovery in growth after last year’s slump.

Following the government’s decision to reduce its borrowing from markets in the first half of the current fiscal year, which led to a decline in bond yields, it seems that the RBI wants to continue to encourage investor confidence. Earlier this week, it said it would allow commercial banks to spread out their loss provisions on bond investments in the last two quarters of fiscal 2018 over as many as four quarters instead of accounting for them in the quarter when they were incurred. This will provide a welcome relief to banks who have experienced a significant depreciation in the value of their bond holdings in the past six months following a rise in bond yields, which has lead to a reduction in bond prices.

Both debt and equity markets responded favourably to the RBI’s decision to leave the repo rate unchanged. The Sensex and Nifty were up by 601 and 208 points, respectively, at the close of trading on March 5th while bond yields fell to 7.13% from 7.30%.

The RBI could be tempted to lower rates if growth is subdued over the next few quarters, which is a definite possibility. Conversely, if inflation exceeds forecasts, we could see a rate hike. The most likely outcome, however, is that the uncertainty will persist, in which case the RBI will do what it does best: nothing.
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