The decision of the Reserve Bank of India's Monetary Policy Committee (MPC) when it meets on October 3-4 is in the spotlight. Rates look likely to be kept on hold, against the current backdrop, for several reasons: (1) inflation has bottomed out, (2) core Consumer Price Index inflation has climbed back above 4 percent, (3) the probability of fiscal slippage has increased, and (4) the Rupee has weakened amid higher oil prices and increased geopolitical risks. The MPC's objective is to achieve the medium-term CPI inflation target of 4 percent +/-2 percentage points, while supporting growth. The latest CPI print was 3.25 percent; we expect it to edge higher over the next few months, but remain below 4 percent as of March 2018.
However, the sharp slowdown in growth, which slipped to a thirteen-quarter low of 5.7 percent year on year in the April-June quarter (Q1FY18), has complicated the MPC's decision. To be fair, any implementation of major policy changes – such as the Goods and Services Tax – usually takes a toll on economic activity. Thus, the slowdown in anticipation of GST implementation is neither unique nor unexpected. Indeed, growth pains are likely to persist for a few more quarters.
However, India's economy was already on a weak footing ahead of GST implementation owing to the lingering impact of demonetisation, announced just three quarters before, and the ‘twin balance sheet' issue. Expectations of monetary or fiscal policy stimulus, therefore, seem justified.
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We see space for a 25 basis point rate cut to 5.75 percent. However, we think it will come in December rather than this week.
This would allow the MPC to get a better sense of structural versus cyclical components of the post-GST growth slowdown. Currently, it is difficult to assess the underlying economic momentum, as disruptive changes have yet to fade.
The MPC is also likely to have more clarity by December on government plans, if any, for additional fiscal spending. The fiscal deficit is under stress as risks of revenue slippage have increased since GST implementation. If the government decides to spend beyond the already-wide deficit – driven by, say, a revenue shock – the MPC might find it difficult to cut rates in December.
Given our view of limited space for fiscal stimulus, we think that the MPC will deliver a rate cut later rather than sooner.
More importantly, such a move could boost confidence, which has languished amid slower growth and several major policy changes. The state of any economy is defined by three pillars: policy, fundamentals, and confidence. In our view, a policy rate cut could support confidence.
Thus, while we expect the MPC to stay on hold this week, we believe it will strike a dovish tone. Continued vigilance is warranted, as CPI inflation is likely to edge higher on the asymmetrical impact of GST on growth, the bottoming out of food inflation and the technical impact of higher rent allowances for public-sector employees. However, with the objective of 'doing no harm', we think the MPC will keep the hope of future rate cuts alive.
The MPC will have completed its first year in operation when it meets this week. Along with its rate decisions and monetary stance, it will be interesting to observe the MPC's evolution over the last year. The voting pattern has shifted from full consensus in the initial period to divergent views and votes among members. The market will keenly watch whether MPC members' views on policy rates diverge further going forward.
Anubhuti Sahay is chief India economist at Standard Chartered.
The views expressed here are those of the author's and do not necessarily represent the views of BloombergQuint or its editorial team.
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