The Governor Raghuram Rajan-led RBI’s tone shifted to being more balanced and markets are likely to take it as a hint of the first rate cut being as early as mid-January 2015. However, we expect the RBI to cut rates in March only after factoring in (1) the Union Budget in end-February and (2) clarity on the disinflationary impulses after the base effects diminish. We factor in 50-75 bps of repo rate cuts in CY2015 based on our estimate that inflation will likely hover around 6% for most part of CY2015. We expect 10-year yields to range at 7.50-8.00% in CY2015 after factoring in the repo rate cuts.
When? First rate cut more likely after Union Budget
The RBI’s statement “… a change in the monetary policy stance is likely early next year, including outside the policy review cycle…” effectively opens up the timing of the first rate cut to a wide window of mid-January (after December inflation release) and early-April (scheduled policy meeting). If an out-of-the-turn policy rate decision is indeed likely, we expect the first rate cut to be in March 2015 after the fiscal aspect is factored in from the Union Budget. Clarity will also emerge on the disinflationary trends through December and January prints, which will enable the RBI to start a rate-cut cycle on a more concrete ground. We think that an earlier cut in January will be likely if the December inflation print is significantly lower than the RBI’s expectation (~5.5%), implying higher-than-expected disinflationary impulses. However, as a central bank starting out on a new monetary policy framework, the RBI will likely want to be sure of the trajectory and be late rather than risk reversals in policy stance.
Why? Disinflationary impulses beyond base effects will drive rate cut conviction
The inflation-based decision to cut repo rate will be driven by (1) sustainability of disinflationary impulses and (2) achieving the glide into the 6% even after rate cuts. These two conditions will receive greater attention over next 2-3 months, a period when the base effect-related drops in inflation will be over and also when some seasonal uptick in vegetable prices could be expected. The consequent changes in the public’s inflation expectations will remain a major input for the RBI as it decides the timing of the interest rate reduction. While the short-term drivers of inflation like commodity prices (global aspect) and minimum support prices (domestic aspect) remain comfortable, the long-term drivers like rural wages and structural frictions (hoarding, storage and logistics) will be important for sustained retail inflation of 4% (+/-) 2%.
How much? 50-75 bps over next one year
We note that the supply-side responses of an investment pick-up to interest rate reductions could continue to be muted. This is because we need an overall strong demand from domestic and external sources to clear out the excess capacities that are present in the economy. Apart from this, the RBI alludes to the fact that the pace of revival of stalled projects is still slow. The above argument implies that India’s potential growth rate will take a relatively long time to rise. The risk that the RBI runs is to cut the interest rates too deep and rekindle domestic demand much more sharply than the supply-side dynamics.
We expect that the RBI would be open to just a 50-75 bps cut in repo rate in CY2015. Further, in our opinion, the probability that the cuts will be delivered in equal doses of 25 bps is much higher. This is because as per the current inflation projection of the RBI “over the next 12-month… inflation is expected to retain some momentum and hover around 6%”.
By Kotak Institutional Equities