By Sachchidanand Shukla
The upcoming RBI policy is unique in the sense that there seems to be an overwhelming focus around its inflation forecasting in view of the CPI inflation print breaching the RBI’s lower bound of 2%. The RBI has not cut the policy rate since last October and has chosen to be cautious despite low inflation prints citing the following concerns in its June policy statement:
The RBI expressed apprehension as to whether or not the unusually low momentum in the reading for April will endure. It projected inflation in the range of 2.0-3.5% in H1 and 3.5-4.5% in H2 with risks being evenly balanced. However, it did cite the risk of fiscal slippages on account of farm loan waivers, along with the 7th central pay commission’s allowances award as an upside risk.
So let us look at what has transpired since on these factors highlighted by the RBI:
Monsoon has covered the whole country ahead of schedule this year and has progressed as per expectations. Kharif sowing has been higher year-on-year and hence should allay fears of food inflation. The output gap is likely to remain negative with growth still being iffy. Pricing power remains weak and high frequency indicators seem mixed at best and highlight the fact that a lot of recent policy induced disruptions and one-offs may weigh over sentiment and output in the near term.
The second round effects of the hike in allowances including HRA by the central government is one area where the RBI, unlike the CEA and others, has been worried. The concern also owes primarily to the different weights being attached to housing by RBI and the CEA. Most likely the first round impact is going to be statistical as a large number of central government employees already reside in government quarters and hence there would not be big financial payoffs. Moreover, as long as the output gap is negative, this should not be a major worry.
Inflation expectation surveys too have trended downwards and the view is that lower food inflation will feed into expectations and the core also going forward. From a global perspective, inflation continues to underwhelm everywhere and seems to have caused the US Fed to sound a lot more dovish despite signalling of the tapering of its $4.5 trillion balance sheet. Oil prices have also remained soft and hence imported inflation should also be less of a worry for the RBI.
Thus, while in June it might have been reasonable to wait and watch, the sharp downward trend of inflation since then means that the RBI can no longer sit on the fence. This leads us to the question of how much space does the RBI have to cut rates then? Based on RBI’s own expectation of inflation being ~4% by January 2018 and a real rate target of ~150 bps, there seems to be enough space for 50 bps cut. However, expectations need to be tempered in view of what Deputy Governor Viral Acharya had to say recently. He mentioned that “tolerance for a slightly higher real rate of interest is justified to ensure weak banks do not find relatively low the hurdle rate for ever-greening of bad loans. What is required for monetary policy to do its job better is to address the stress on bank balance sheets”. But then, will a small rate cut (read 25 bps) really move the needle on growth in the backdrop of a system sloshing in liquidity of ~Rs 4 trillion? The RBI has cited poor transmission several times through this rate cycle already. Low capacity utilisation levels, leveraged balance sheets and tepid demand mean that a small rate cut may end up being merely symbolic.
(Author is Chief Economist at the Mahindra group. Views expressed in this article are personal)