RBI Judiciously Holds Back

The run-up to this policy was quite interesting. The previous policy statement had alluded to upside risks to inflation but inflation turned the other way. The sharp fall in headline retail inflation brought back market focus on a likely easing action by the Reserve Bank of India and voices condemned the RBI of getting inflation forecasts horribly wrong. Having said that, most economists on the street some two months back were looking at the inflation trajectory as not being much different from that of the RBI's and are themselves scampering to change their inflation forecasts. Further, some tended to argue that given the sharp appreciation pressure on the Rupee, financial conditions have anyways tightened and hence some loosening from the monetary policy side could be due.

Thus, there were expectations for the RBI to change its inflation forecast which it did. RBI has now brought down its first half inflation target to 2-3.5 percent from a 4.5 percent average earlier, while the second half number has been reduced to 3.5-4.5 percent from an expected average of 5 percent. The RBI continues to maintain that the risks to inflation are “evenly balanced”, but goes on to say that there might not be an immediate clear understanding if the “unusually low” momentum of the April inflation numbers (sub-3 percent) will sustain.

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Definitely, some of the risks to inflation that RBI had alluded to in its April policy have started to fade. Crude prices and global commodity prices are in a narrow side-ways channel and the fear of a ‘Trump Trade' erupting into a very aggressive United States Federal Reserve and hence a possible sharp depreciation pressure of the rupee is possibly a thing of the past. There is clarity that the Goods and Services Tax is unlikely to have a very large implication of pushing inflation up by a large margin. For the RBI, some risks to inflation do remain in the form of the monsoon distribution, payment of the Seventh Pay Commission allowances, and the fiscal implications of the farm loan waivers. The RBI also thinks that rising rural wage growth and expected strong consumption demand could mean that the recent dips in core inflation could be transient.

IDFC Bank's own estimates at this point indicate an average inflation of 2.4 percent in the first half and increasing to an average of 3.7 percent in the second half.

What could remain crucial for the RBI is that even with a lower trajectory for inflation, headline retail inflation could still head up to around 4 percent, the durable anchor level for the inflation targeting framework.

RBI also believes under the current economic backdrop of a need to revive private investment, restore banking sector health and remove infrastructure bottlenecks, the effectiveness of any monetary policy signal can be blunted.

Further, without a significant clarity and understanding of the inflation dynamics, the risk of cutting rates immediately could be large and might also later lead to disruptive reversals in the policy rate. Such flip-flops are obviously best avoided. Instead, the RBI continues to play the liquidity route and cuts the Statutory Liquidity Ratio requirement by 50 basis points or half a percentage point – releasing around Rs 60,000 crore for the banking sector – and providing scope for lending to deserving sectors. With this view, the risk weights for the housing loans that also have a low delinquency rate are being reduced to provide a credit push to this sector.

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The key question now – will this low inflation trajectory and RBI's acknowledgement of the same lead to an August rate cut? This comes into focus even more sharply as the next couple of inflation readings are likely pointing at headline retail inflation moving closer to the 2 percent mark.

The simple point being – given RBI's mandate of bringing inflation down to 4 percent on a durable basis, it may not be in a position to cut rates when inflation is projected to move close to 4 percent mark sometime during the second half of the financial year. Only if clarity emerges that inflation would sustain significantly below the 4 percent mark on a durable basis could the RBI significantly warm up to a softer monetary policy.

Indranil Pan is Group Chief Economist at IDFC Bank. Views 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.