The backdrop for the Reserve Bank of India's third bi-monthly policy review for 2017-18 (FY18) had managed to evoke a variety of responses from market participants. While the consensus favored an outright 25 basis points rate cut, other compelling arguments were also put forth in the market โ one expecting a monetary status quo, while the other anticipating a deeper rate cut of 50 basis points.
The central bank eventually delivered a 25 basis point rate cut โ in line with the broader consensus expectation โ thereby taking the benchmark repo rate down to its lowest level since October 2010.
A Non-Committal Stance
The resumption of monetary easing after a hiatus of nine months is an acknowledgment of:
- Undershooting of actual inflation vis-ร -vis the RBI's projected trajectory in Q1FY18.
- Emerging languidness in upside inflation risks cited by the Monetary Policy Committee over the last few months.
To be sure, inflation in India has immensely benefitted from the trifecta of sound food management by the government, subdued pricing power amidst low capacity utilisation, and a benign global and financial market environment.
This along with the RBI's embracing of the flexible inflation targeting regime has started to gradually alter inflation expectations in the economy.
- Professional forecasters now expect the long-term inflation (over the next ten years) to stay close to 4 percent levels, a drop of around 2 percent in the last three years.
- Over the last three years, household inflation expectations have nearly halved to around 6.3 percent currently.
These are early signs of success for a nouveau inflation targeting central bank. The Monetary Policy Committee (MPC) would, in fact, make sure that such an out-turn is replicated on a durable basis and hence could continue to err on the side of caution in the near future.
Caution could stem from various sources. The seasonal food price pressures have started to emerge โ in tomatoes, onions, milk, etc.
The impending implementation of the Seventh Pay Commission by states along with the rollout of farm loan waivers by a select few would not only impact the quality of fiscal adjustment, but it could also pose a potential upside risk to medium term inflation trajectory.
While these are known risks, the unknown risks could emanate from the global side with the United States Federal Reserve already hinting at unwinding of quantitative easing, later this year โ something for which there is no historical precedence.
While one needs to be mindful of upside inflation risks, ongoing changes in the economic order should also be accounted for. Take, for example, the forces of creative destruction unleashed by three structural moves in a short span of time โ Demonetisation, Bankruptcy Code, and the Goods and Services Tax. In the short term, demonetisation is working towards enhancing financial efficiency.
In the medium term, the bankruptcy architecture and GST will unlock investment potential and boost economic efficiency significantly.
These capacity augmenting reforms are bound to have a disinflationary impact over the medium term. Globally, policymakers have started debating on the possibility of a change in slope for the Philips Curve โ this per se could lead to a reassessment of neutral interest rate in key advanced economies with the likelihood of a lower bias.
With both short and medium term factors complicating the overall monetary policy maze, it is best to maintain an owlish stance โrather than hawkish or dovish โ and be nimble enough to react to the evolving situation.
This is precisely the message one gets from reading between the lines of the RBI's monetary policy statement.
With the expectation of continued undershooting of food inflation relative to historical patterns, persistence of negative output gap in the near term, a benign global commodity and currency market environment, and on-boarding of revised FRBM guidelines from FY18 onwards could help in keeping inflationary pressures subdued (Yes Bank expectation of 3.5 percent average inflation in FY18 vis-ร -vis 4.5 percent in FY17). This could potentially open up room for a further 25 basis point rate cut in Q3FY18.
Looking Beyond Interest Rates
With the neutral stance likely to be in place for some time now, it is imperative to leverage other policy tools to reinvigorate growth. Credit impulse in the economy can be boosted via faster project clearances and time bound resolution of twin balance sheet problem. Focused prudential regulatory forbearance for easing credit availability in select sectors could also get evaluated.
Shubhada Rao is group president and the chief economist at YES Bank. 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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