Acting along expected lines, the monetary policy committee kept the repo rate unchanged at 6 percent, with five members voting for ‘status quo' and one member for at least a 25 basis point cut. The stance of the policy remains unchanged too, at neutral. The statement is balanced with risks both to inflation and growth highlighted and baseline forecasts revised accordingly.
The key revision is to the growth trajectory. Taking into account April-June 2017 gross value added growth of 5.6 percent year-on-year, and the slow pace of recovery in Q2FY18, baseline GVA growth forecast for FY18 was reduced to 6.7 percent from the earlier estimate of 7.3 percent. The recovery is expected to gather pace in the second half of the year as challenges around the Goods and Services Tax are resolved, with average growth of 7.4 percent in H2FY18, up from 6 percent in H1. FY19 GVA growth is projected at 7.4 percent.
The MPC awaits more evidence to decide if the growth slowdown is due largely to transient factors, or is it structural in nature.
On the inflation front, the baseline forecast path has been revised upwards on account of higher oil prices (which are now seen averaging at $55 per barrel in H2FY18), food price normalisation and higher core inflation driven by statistical impact of house rent allowance increase, and a broad-based increase in other components of core inflation. Headline consumer price index inflation in the baseline scenario is seen averaging at 4.4 percent in H2FY18 (4.2 percent in Q3 and 4.6 percent in Q4), up from 4 percent earlier and rising to 4.6 percent in Q1FY19. Average inflation from the second half of FY18 through FY19 is projected at 4.6 percent.
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The monetary policy report accompanying the statement lays out various risks to baseline projections of inflation and growth. While the risks to the growth forecast are evenly balanced, risks to inflation are seen on the upside, especially from the states' implementation of the HRA increase (which is seen adding 100 basis points to inflation over the baseline). Food prices are seen having the most significant impact in relation to the projected inflation path. If for instance, softening of food prices – seen since the second half of 2016 – persist, then the headline inflation in rest of the fiscal year could be below the baseline by 2 percent. Persistence of low momentum of food price inflation would also be a seen as a structural downward shift which is sustainable.
If on the other hand, the food price correction is cyclical and there is a reversion to the long-term momentum, then headline inflation may turn out to be 1 percent higher than the baseline.
Going forward, the space for any monetary accommodation, therefore, would critically depend on whether food price inflation has indeed come down structurally – on account of moderate increases in the minimum support price and improvement in yield of cereals and pulses – or turns out to be cyclical and reverts back to its long-term mean.
The balance of risks to the inflation trajectory is broadly on the upside and can come from a shortfall in the summer crop production, farm loan waivers by states, possible fiscal stimulus by the centre, and the implementation of higher pay and allowances by state governments.
Fiscal slippage with an overshooting of fiscal deficit to GDP ratio by 50 basis points by the central government is seen driving inflation higher by 25 basis points in FY18.
And, a $10 per barrel spike in crude oil prices (above the $55 per barrel), is seen driving inflation up by 30 basis points over the baseline and growth weakening by 15 basis points.
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With this growth and inflation profile in place to guide future policy actions for the rest of the year, any further monetary accommodation will be contingent upon growth not holding up or inflation undershooting. While a recovery in Q2 is underway led by consumption, the pace of remains slow, something which the MPC has taken into account. At this juncture, the RBI projections suggest the economy will revert to its potential growth levels by Q3 and momentum is likely to improve over Q4.
Hence, unless the Q2 GVA growth is significantly weaker than the 6.4 percent pencilled in by the RBI, growth concerns are unlikely to take precedence.
To support growth, the MPC statement reiterates the need to revive investment activity while easing the supply side constraints, especially in the infrastructure sector, and enhancing ease of doing business including simplification of GST.
Similarly, on inflation, if risks such as higher oil prices, weaker exchange rate, the possibility of a shortfall in foodgrain output or a fiscal slippage do not materialise, then the projected inflation path could see some undershooting. For instance, a 5 percent appreciation of the rupee against the U.S. dollar is seen softening inflation by 20 basis points, while with a $5 per barrel decline in oil prices back to an average of $50, headline inflation is seen moderating by 15 basis points. An out-turn of food price inflation may turn out to be more crucial though, especially as it may drive overall inflation lower on a sustainable basis.
Evidence on the nature of food price inflation will thus be watched closely in the next 3-6 months.
In the meantime, a prolonged pause with a neutral stance seems to be the base case scenario for monetary policy for this fiscal year.
With abundant liquidity and RBI's efforts to further improve monetary transmission of past rate cuts, will allow for the overall rates environment and financial conditions to remain broadly supportive of growth. By reducing the Statutory Liquidity Ratio requirement of banks' by 50 bps to 19.5 percent of their net demand and time liabilities, the RBI is aiming to reduce frictions in monetary transmission and curb financial repression further.
Gaurav Kapur is the Chief Economist of IndusInd Bank. Views expressed here are personal.
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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