Rate cut policy and its reasons:-

The MPC unexpectedly cut the benchmark Repo rate by 25bps, from ​6.50% to 6.25% on 7
February 2019 through a split vote.In an unanimous vote, the monetary policy stance was changed
to ‘neutral’ from ‘calibrated tightening’.Reasons for this cut are:-
1) Sharp downward revision to inflation forecasts​ from 3.2% to 2.8% forJan-Mar’19
appears to be a key trigger for this cut, whereas H1 FY20 inflation has been revised down
by 60-80 bps, to 3.2-3.4%yoy.Crude prices are more or less at similar levels as at
December review and INR is only modestly weaker (by 1.4%).
2) Weaker growth outlook​ is the second key trigger for the rate cut. It also pushed down
inflation forecast. The RBI believes that the output gap has opened up modestly recently, after
earlier assuming that the gap had virtually closed. With inflation forecast for CY19 well below
the 4% mid-point of target range, it was likely felt that the recent soft patch in growth should be
accommodated as part of the flexible inflation target regime.The FY20 FD estimate of 3.4% is
30 bps higher than the FRBM target, is a good sign as FD is increasing in the regular Budget.
3) Expectations of further ​drawdown in household inflation ​is one of the reasons.The results
show a sharp drawdown in not just the three month ahead inflation expectations (by 80 bps),
but even the one year ahead expectations by 130 bps.The persistently low food inflation and
recent correction in fuel prices have had a salient effect on inflation expectations.
First​, it appears rather hasty on part of MPC to overlook core inflation pressures witnessed recently.
Recall core inflation ex auto fuels and housing components accelerated 10% mom sa annualized over
Oct-Dec.It was explained as One-Off phenomenon by MPC. ​Second​, we believe RBI’s new inflation
forecasts for FY20 have been adjusted too low. We expect CPI inflation to evolve more in line with
RBI’s old forecasts than the new. Thus, Jan-Mar inflation could average a little above 3%, while
H1FY20 inflation could be 50 bps higher than RBI projections, at 3.9%.The RBI is exercising
judgement to err on lower inflation outcomes rather than higher given the public criticism for past
forecast errors. ​Third​,​ ​The MPC considered policy settings to be tight relative to expected inflation
outcomes, which is seen undershooting 4% in CY19. Policy rate fixings should thus be considered
suitable, rather than overly restrictive. Further, the part of CPI basket that should be most sensitive to
policy fixings i.e. core has surprised higher recently. Evidently the majority in MPC has judged that
growth risks are real enough to warrant a response which could not wait for more clarity on inflation.

Signal of more Rate cuts:-

The Governor did signal that in case inflation evolves in line with forecasts, there may be scope for
more policy action. The risk then is of another 25 bps cut in April policy itself as material upside risks to
inflation may not arise in short order.

Effect on Bond Market due to Rate cut:-

The yield curve steepened and was expected this trend to continue. Substantially higher auction sizes
in H1FY20 and reduced OMO support from RBI will affect the curve and short-end may be well
supported by excess liquidity conditions. We expect OMO amounts to start tapering from March itself
with Rs 300 bn worth of purchases likely should RBI decide to pay interim dividend of Rs 280 bn.