Abheek Barua*
The pause in the rate cycle 
comes as a surprise given the dismal growth for the second quarter of 2019-20 and the likely persistence of a slowdown. Clearly the RBI has responded to hardening headline inflation and rising inflation expectations of households.
This suggests two things. Any sustained increase in headline CPI inflation (whether or not it is primarily driven by supply shortages that the RBI itself acknowledges as transitory) above the median of the target range of 2 to 6 per cent will make the MPC anxious and translate into a pause. It also seems that the RBI wishes to see the lagged impact of its front-loaded 135 basis point cut in the policy rate along with how some of the fiscal measures play out for future growth.
The governor seems to suggest that there is an optimum timing for further rate cuts. In the absence of any indicators that define this “timing”, it makes the policy path from here on somewhat uncertain. Given the RBI’s focus on recent inflation spikes and its near-term forecasts (4.7-5.1% in H2), there is a possibility that the RBI might stay on hold even at its next policy meeting in February. We expect the inflation readings until February to remain above 5%. Moreover, if fiscal policy is expansionary in the upcoming budget and provides some support for growth, the RBI could further be convinced to hold back rate cuts.
So, what could lead to further rate cuts by the RBI? The absence of any significant counter cyclical measures in the budget, signs of some flattening out of food inflation and undershooting growth numbers could build a case for further rate cuts.
We expect some tightening in bond yields in response to this surprise. At the time of writing, the 10-year yield had risen by 11bps to 6.57%. The markets had priced in a rate cut before the policy meeting and a pause in the policy rate is likely to keep yields elevated in the near-term, within a range of 6 .50-6.60%. That said, over the medium term, we expect yields to come down somewhat and trade in the range of 6.40-6.50% by March-end. The current level of the yield has significant fiscal slippage and consequently additional market borrowings in Q4 priced in. However, we believe that additional market borrowings by the government could be lower than the actual fiscal slippage (our estimate of Rs. 84,000 crore) as the government could tap into the small savings fund.
On credit growth, given the paucity of loan demand, banks are likely to chase assets and the transmission process could gain traction. However, the flight to safety and large risk premiums for risky borrowers will persist.
Download HDFC Bank Report on RBI Policy
*Mr. Abheek Barua, Chief Economist, HDFC Bank. Mr. Barua tweets at @AbheekHDFCBank.
