Will It? Won’t It? Inflation Targeting-MPC Meets Amid Mixed Economic Signals

India's Monetary Policy Committee meets this week against a backdrop of severe economic stress. The number of cases of Covid-19 detected in the country is still rising and local lockdowns have diluted the push to reopen the economy.

While demand remains weak, there are signs that inflation isn't yet responding to those conditions. This will pose a dilemma for India's inflation targeting-MPC, which meets the last time under its current four-year term.

Economists are divided on whether the MPC will rule in favour of another rate cut. A Bloomberg poll of 42 economists shows that 21 expect another 25 basis point cut this week, while 20 economists expect a status quo. The economists at Rabobank expect a 50 basis points cut.

The MPC has already cut rates by 115 bps since the Covid crisis hit in March, bringing the repo rate down to 4%.

Is There Still Space For Easing?

Assessing how low policy rates can fall is challenging in an environment where trends on growth and inflation are changing rapidly. However, some economists are applying the Taylor Rule to judge the terminal repo rate.

Kaushik Das, chief India economist at Deutsche Bank, uses the Taylor Rule to peg the terminal repo rate at 3.7%, he said in a note dated July 20. Deutsche Bank's baseline forecast is for CPI inflation to average 4.8% in FY21 and real GDP growth to average about 3% year-on-year over the next seven quarters including the July-September'20, where growth is expected to contract 8.5% year-on-year.

Using this longer run growth, rather than just FY21 growth, Das said the Taylor rule suggests that repo rates can settle at 3.7%.

The Taylor rule helps determine the terminal interest rate based on the real interest rate; the difference between the current level of inflation and the targeted level of inflation; and the output gap, which is the difference between the current and potential output.

In a research note dated July 30, Rahul Bajoria, chief India economist at Barclays, said that the RBI will likely cut the repo and reverse repo rate by at least 25 bps to 3.75% and 3.10%, respectively at this week's meeting. “We still see the terminal repo rate as being 3.50%, which we now believe will be reached in Q4 2020, instead of Q3,” Bajoria said.

In contrast, Pranjul Bhandari, chief India economist at HSBC, sees the possibility of a pause in rates.

Economic Rebound Patchy

A rebound in economic activity after the lifting of nationwide restrictions has been followed by a flattening of the recovery curve.

The rising number of active cases of coronavirus have forced policy makers to enforce localised lockdowns. Rating agency ICRA now estimates GDP to contract by 9.5%, from it's earlier forecast of a 5% contraction.

Concurrent indicators have shown mixed trends. The Markit India Manufacturing PMI dipped to 46 in July after it rebounded to 47.2 in June. Diesel demand in July was down 21% year-on-year compared to 15% in June, according to a Credit Suisse report. However, e-way bill collections improved as did power consumption, which rose 5% year-on-year in the latest week for which data is available.

Inflation Dynamics May Remain Complex

While there is no doubt that demand is weak, complex inflation dynamics may weigh on the MPC's decision, given its legal mandate of maintaining inflation at 4%, within a comfort band of +/-2%.

At 6.09%, CPI inflation remains at the upper bound of the MPC's target.

HSBC's Bhandari estimates that inflation could average 5% in FY21. She flags off three factors. First, real rates, which have been a driver of inflation in the past, are moving towards the negative terrain after six years. In addition, there is a risk of inflation expectations getting unanchored and further supply disruptions could emerge if viability of a larger number of firms becomes a challenge.

The RBI has not provided year ahead forecasts for inflation so far.

Deutsche Bank's Das, however, believes the June inflation print over-estimated price pressures, partly due to the methodology used to impute it. He believes that core inflation is much lower. “RBI's preferred core inflation measure excluding transport and communication inflation yields a core inflation rate of 4.4% year-on-year in June and excluding gold, the core inflation rate falls further to 3.5% in June vs. 3.8% in May, 3.7% in April and 3.2% in March, as per our estimates.”

Interest Rate Transmission

While transmission of interest rate cuts in India is typically slow, it has been quicker this time due to surplus liquidity conditions.

The Weighted Average Lending Rate for all banks stood at 8.54% in May 2020, compared to 9.36% in January this year, shows RBI data. The policy rate has been cut by 115 bps over this period.

However, real lending rates, adjusted for core WPI as a proxy for pricing power, remain high and constrain recovery beyond the Covid-19 shock, said BofA Securities in a report dated 26 July 2020.

By several metrics, India's monetary transmission has become slower at the margin, said Bajoria, even though new loans are being priced by reference to an external benchmark. This means the RBI should ease monetary policy now, if it is to factor in lowering lending rates in 12- 18 months, he added.

Given the increasing focus on the state of India's financial system, especially the level of non-performing loans, the RBI may want to lower the system-wide cost of funds, which could help reduce deposit rates offered by banks, he said.