Demonetization halts consumer spending
The Indian government’s move to withdraw over 85% of currency notes in circulation by value in November 2016 had disastrous consequences for domestic consumption. This is expected to weigh on the pace of India’s economic growth, though estimates of the impact wary widely.
When the MPC (Monetary Policy Committee) of the Reserve Bank of India had met in December, there were expectations that it would cut its key repo rate in order to support the economy. However, there were some arguments that the central bank may wish the demonetization process to end — which it was scheduled to on December 30, 2016 — before tinkering with interest rates.
Thus, when the MPC met again in February, several market participants expected a reduction in the repo rate, but it was not to be.
The reasons why the Reserve Bank of India held back
The primary reason that led to a status quo decision by the Reserve Bank of India on the repo rate was inflation. This may sound contrary to facts and to market beliefs that we had outlined in the first article of this series.
The central bank has a target of keeping inflation at or below the 5% mark by March 2017. In the medium-term, it aims to keep inflation at around 4% within a band of +/- 2%.
Retail inflation, as measured by the consumer price index, had risen by 3.4% in December 2016. Given the depressed food prices and fall in consumption due to demonetization, it looks like the Reserve Bank of India is comfortably on a path of achieving its target by March 2017.
However, the central bank sees inflation risks emanating from rising crude oil prices (USO). Crude oil forms a third of India’s imports, thus exposing it to increased inflation.
In the press conference following the two day meeting, central bank governor Urjit Patel also observed that core inflation, which excludes food and fuel prices, had remained stubborn.
There were also likely other factors at play which could have deterred the Reserve Bank of India from cutting rates. Let’s look at them in the next article.