IN: Reserve Bank of India

December 7, 2016 03:00 CST

Consensus Actual Previous
Change -25bp 0bp -25bp
Level 6.00% 6.25% 6.25%

The Reserve Bank of India left its main policy rate, the repurchase rate, unchanged at 6.25 percent, contrary to the consensus forecast for a cut of 25 basis points. This rate was cut by that amount in October and April. The decision taken to keep rates on hold was unanimous among members of the Monetary policy Committee, with officials arguing that the current policy stance is consistent with their medium-term goal of keeping headline inflation in a target range of 2.0 percent to 6.0 percent.

A rate cut was widely anticipated today after PMI surveys released over the last week showed a sharp fall in business activity in November. This was largely driven by cash shortages in the economy after the government announced early in the month that it would withdraw high-denomination notes as legal tender as part of efforts to curb tax avoidance and corruption.

The RBI's decision to leave policy unchanged suggests that officials expect the negative impact of this government's decision to be relatively limited and short-lived. The statement accompanying the decisions explicitly notes that the near-term outlook is "clouded" by the currency withdrawal, but that "a fuller assessment is awaited". Officials expect interruptions to "some" parts of industrial activity in November and December and see downside risks for the near-term due to short-run disruptions in cash-intensive sectors of the economy and adverse wealth effects. However, they believe the impact of the first of these two factors will be temporary and that the impact of the second factor will be "limited". Nevertheless, the RBI's growth forecast for the current fiscal year has been revised down from 7.6 percent to 7.1 percent.

Officials also expect the currency withdrawal to dampen inflationary pressures in the near-term, estimating that there could be a temporary reduction in inflation "of the order of 10-15 basis points" in the current quarter. Headline CPI inflation has already fallen sharply in recent months, as positive rainfall patterns in the annual monsoon season helped to bring down food price inflation. The RBI now forecasts 5.0 headline inflation for this fiscal year, with risks skewed to the upside but lower than their previous estimates.

Despite the significance of the currency withdrawal decision and its impact on the outlook, officials have stressed in the statement the importance of not over-reacting. In particular, they argue that "it is important to analyse more information and experience before judging their full effects and their persistence short-term developments that influence the outlook disproportionately warrant caution with respect to setting the monetary policy stance." They suggest that growth may rebound quickly and also warn that some food prices are showing "sustained firmness and a pick-up in momentum". Officials are also concerned that consumer prices for items other than food and fuel have not shown "downward flexibility", suggesting that there is less room for headline inflation to fall. As a result, they conclude it is appropriate to "look through the transitory but unclear effects" of the currency withdrawal.

Another factor that appears to have supported the case for policy stability this month is the likely increase in policy rates in the United States next week. Officials described such a move as "imminent" and the cause of recent bouts of high volatility in global markets. With the Indian currency already selling off sharply in recent weeks, officials likely assessed that a rate cut now would prompt additional capital outlaws.

These factors suggest that it remains an open question what the RBI will do at its next policy meeting, scheduled for early February. If the impact of the government's decision proves to be more disruptive and long-lasting than currently anticipated, the RBI will likely face intense pressure to provide policy relief. However, if the RBI's sees signs that the impact is waning by then, officials may conclude that further policy stability is warranted.

The Reserve Bank of India (RBI) issues six Bi-monthly Policy Statements a year. During these announcements the RBI will signal any shifts in its monetary stance, particularly with reference to the benchmark repo interest rate and its cash reserve ratio (CRR). The Governor will also update the Bank's view of recent economic developments and provide new forecasts for inflation and growth. A 4 percent inflation target with a +/- 2 percentage point tolerance band was formally implemented in August 2016 and will be overseen by a new six-member Monetary Policy Committee (MPC).

Although the RBI monitors many economic indicators - as indeed all central banks do - the RBI most closely monitors inflation. The level of interest rates affects the economy. Higher interest rates tend to slow economic activity while lower interest rates stimulate economic activity. Either way, interest rates influence the sales environment. In the consumer sector, fewer homes or cars will be purchased when interest rates rise. Furthermore, interest rate costs are a significant factor for many businesses, particularly for companies with high debt loads or for those who have to finance high inventory levels. This interest cost has a direct impact on corporate profits. The bottom line is that higher interest rates are bearish for the financial markets, while lower interest rates are bullish.

The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. The Reserve Bank's affairs are governed by a central board of directors. The board is appointed by the Government of India in keeping with the Reserve Bank of India Act.

The Reserve Bank of India performs this function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India. Primary objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies. Its function is to advise the Central Board on local matters and to represent territorial and economic interests of local cooperative and indigenous banks; to perform such other functions as delegated by Central Board from time to time. Primary objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies. The Board is required to meet normally once every month. It considers inspection reports and other supervisory issues placed before it by the supervisory departments.