The Monetary Policy Committee (MPC) retained the repo rate at 6% but the yield on government bonds has moved down sharply. This shows that it is not just any change in the policy rate that matters, but the policy statement as a whole, particularly the prognosis on inflation in the months to come. The MPC has slashed its inflation expectation sharply, to 4.7-5.1% in the first half of 2018-19 and to 4.4% in the second half, even as GDP growth for the current fiscal is forecast to accelerate from 6.6% last fiscal to 7.4%. The market has reacted to this happy picture of the near future. The question that would naturally arise is, why, then, hold the rates now, instead of slashing them to give added momentum to a burgeoning pick-up in investment? The RBI sees some risk of inflation moving up from its forecast rates and is preparing for it. One member of the MPC even voted for a rate hike.
There are two kinds of risk to the comfortable inflation expectation. One kind is outside the control of domestic agents. How fast and how disruptively US monetary policy reverses extra accommodation of the recent past is one such factor. The Monsoon, forecast to be normal as of now, is another. Oil prices are a third. The other kind of risk to inflation comes from the political economy of the country. Farm distress has persuaded the government to announce steep increases in the minimum support prices of assorted crops. How precisely this would pan out is not known at the moment.
There is the likelihood the combined fiscal deficit of the Centre and the states could prove to be higher than what it is projected to be at the moment. In a year that is politically crucial, both for the key assembly elections that will take place over the course of it, and on account of the general elections that will take place early in the next fiscal year, fresh bouts of farm loan waivers and other such shows of fiscal largesse cannot be ruled out. The move by the RBI to further liberalise trade in interest rate derivatives is welcome, as regards both who can participate in the market and what instruments are on offer. This is essential for debt market development.