The stage is getting set for the Reserve Bank of India Monetary Policy Committee to deliver on market expectations of a 25 basis point cut in the policy rate, after a gap of 10 months. However, more importantly, if the RBI obliges, then this will be the first rate cut after the RBI changed its monetary policy stance from “accommodative” to “neutral” in April. Clearly, this will be a significant departure and not an easy decision for the MPC. However, in our view, the balance of risks indicates that there is scope for a 25 basis point rate cut in August, as long as the focus remains on inflation 9-12 months ahead.
June headline Consumer Price Index inflation at less than 2 percent and core CPI at sub-4 percent are indicating a very benign inflationary environment. But how did we get here from inflation being one of the major macroeconomic risks not so long back?
A quick look indicates that headline CPI has fallen 423 basis points in the last one year but 94 percent of the decline is due to food prices.
In particular, pulses and vegetables explain 73 percent of the drop.
Looking through this lens, the decline in inflation looks less impressive as pulses and vegetables have three and five times more inflation volatility than headline CPI. This ‘cobweb' pattern of demand-supply responses and price formation keeps the risk alive for inflation rates of these products to mean revert. We have seen this happening for tomatoes in June-July and others might follow suit as deflation in food prices is clearly not sustainable given that it exposes farmers to income vulnerabilities.
Despite this risk of mean reversion in some food prices, we think that chances of a rate cut remain alive because of the following reasons.
- First, if we just focus on the last 3 months, headline inflation has dropped 170 basis points and 21 percent of the fall is because of core inflation being on a declining trend. In fact, the core inflation measure has dropped around 100 basis points since the last rate cut in October, after having stayed in a 20 basis point range for 24 months before that. The volatile components of pulses and veggie prices have contributed a relatively low 34 percent of the fall in the headline number. This is indicating a better “quality” of inflation moderation in the recent past.
- Second, acknowledging the lower trend in CPI, the RBI had already slashed its CPI forecast for the 2017-18 financial year (FY18) by around 100 basis points in the June policy. It expected April-September (H1) CPI in the range of 2-3.5 percent rising to 3.5-4.5 percent in October-March (H2) and was in a wait and watch mode to understand how durable is the fall in inflation. However, the lower than expected reversal in food price inflation has meant that the headline CPI has already fallen below the RBI projected range for H1. This persistent inflation “surprise” could be another reason to tweak policy rates, although in some sense this is lagged data.
- Third, rate cuts could be justified given that the flexible inflation targeting framework of the RBI is dependent upon future inflation. According to our forecasts, the March 2018 CPI could be below 4 percent if the transitory effect of 50 basis points from the Seventh Pay Commission house rent allowance increase is adjusted for. This should in principle, open up the space for a 50 basis point rate cut in FY18 assuming the RBI guidance of a real policy rate of 125-175 basis points.
- Fourth, several event-driven inflation risks appear to be on the downside. Monsoons and consequent progress in sowing activity appear to be normal. The weighted average increase in minimum support price of 5.8 percent for FY18 has not been too different from the previous year. The Goods and Services Tax introduction has not led to any significant noise about price increases and based on the change in tax rates there could be even a small downward bias to CPI. Global commodity prices have remained relatively benign, further comforted by a stable exchange rate.
While all these factors justify our comfort on the inflation trajectory and hence on modest space for monetary easing, we need to appreciate the concerns which might prompt the RBI to hold in August – a small probability event though. The activity data appears to be mixed and distorted to some extent because of the GST effect in the near term. The private investment cycle is depressed but most likely because of issues other than just the interest rate.
So in some sense, there is not much urgency to highlight the ‘growth' objective of the monetary policy framework. In any case, some of the MPC members have highlighted that the growth impact of small rate cuts could be limited at this juncture given the financial health of corporates and the banking system.
In our view, any space for providing support to growth, however limited, should be exploited as long as the RBI is confident about sticking to its inflation goal.
A very different argument for keeping rates on hold and real policy rates high arises if the objective of the monetary policy framework is extended beyond inflation and growth to include financial stability too. One of the deputy governors of RBI has indicated his preference to keep real policy rates higher than usual to avoid ‘evergreening' of non-performing assets while the insolvency proceedings are being pushed.
On the other hand, the sharp and sustained rally in equity markets could make the MPC cautious about further easing.
While these are important considerations for a central bank, focusing on too many policy objectives could cloud the communications around the core inflation targeting framework.
A rate cut in the August policy is expected but we remain somewhat cautious that without the RBI becoming more explicit about future softening of monetary policy stance, the downward bias in government bond yields could be limited from current levels. Any such declining trend will have to overcome the hurdles of open market operation sales and risk of global monetary tightening too. RBI may grant the market's wishes by delivering a rate cut but the cheer might be missing.
Samiran Chakraborty is Chief Economist, Citi India. Click here for disclosures.
The views expressed here are those of the author's and do not necessarily represent the views of Bloomberg Quint or its editorial team.
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