Keeping in mind that the MPC’s focus is on the medium to long-term expected inflation trajectory, and that there is a lag in the reaction of inflation to interest rate changes, the significant widening in the output gap and inflation continuing its downward trend after peaking at 13, 6 per cent in August 2008, allowed for the MPC to reduce the repurchase rate by 500 basis points between December 2008 and August 2009.
The contraction in economic activity and the change in the monetary policy stance impacted the domestic bond market in two ways. Firstly, while monetary policy easing exerted some downward pressure on bond yields, this was counteracted by increased supply of government bonds. Given the rapidly slowing economy, revenue intake was substantially lower than projected, causing an increase in the budget deficit.