India Holds Interest Rates Unexpectedly After Demonetization

02:28, 7th December 2016

(RTTNews) - India's central bank unexpectedly kept its key interest rate unchanged on Wednesday as policymakers decided to wait to judge the impact of the drastic demonetization measure on the economy and any policy tightening by the U.S. Federal Reserve next week.

The Monetary Policy Committee of the Reserve Bank of India, headed by Urjit Patel, unanimously decided to hold the key repo rate at 6.25 percent and reverse repo rate at 5.75 percent.

The repo rate was last reduced by a quarter-point in October at the first meeting chaired by Governor Patel. Economists had widely expected a 25-basis point reduction in key rates in his second meeting, as the banks were flooded with funds after demonetization, while lack of funds among consumers dent demand.

This was the first meeting after India withdrew the legal tender status for highly transacted currency notes of INR 500 and INR 1,000 in a surprise move on November 8, citing their rampant use in illegal activities and a high incidence of fake bills.

"While supply disruptions in the backwash of currency replacement may drag down growth this year, it is important to analyse more information and experience before judging their full effects and their persistence," the bank said in a statement.

Policymakers also decided that it was "appropriate to look through the transitory but unclear effects" of the currency withdrawal while setting the monetary policy stance.

Further, the RBI observed that the imminent tightening of monetary policy in the U.S. is triggering bouts of high volatility in financial markets, with the possibility of large spillovers that could have macroeconomic implications for emerging market economies.

If demonetization turns out not to be as damaging as the anecdotal reports suggest, a rate cut today could have been reversed in early 2017, economists at Capital Economics said.

However, if economic activity has been damaged as much as many fear, the RBI's wait-and-see approach will come to be seen as complacent, they added.

The central bank lowered its growth outlook for fiscal 2016-17 to 7.1 percent from 7.6 percent. According to the RBI, the outlook for growth has turned uncertain after the unexpected loss of momentum by 50 basis points in the second quarter. Also, the effects of the high value currency ban are still playing out, the bank noted.

Inflation is expected to slow by 10-15 basis points in the December quarter due to the currency ban. Headline inflation is projected at 5 percent in the March quarter of 2016-17 with risks tilted to the upside.

The downward inflexibility in inflation excluding food and fuel was "disconcerting, which could set a resistance level for future downward movements in the headline figure, the bank pointed out.

The RBI also withdrew the incremental cash reserve ratio of 100 percent on deposits September 16 and November 11 on Wednesday, which it had announced on November 26 to absorb excess liquidity in the system following the demonetization.

The liquidity released due to the discontinuation of the incremental CRR would be absorbed by a mix of market stabilization scheme and liquidity adjustment facility operations, the bank said.