The outcome of RBI’s fifth bimonthly monetary policy review this year was music to everyone’s ears. While the central bank maintained status quo by keeping repo rate unchanged at 8%, it unambiguously signaled for the first time that a change in monetary policy stance is likely early next year. It added beats to the music by hinting at the likelihood of a rate action outside the scheduled policy review cycle.
And sure, the markets rejoiced! The 10-year government bond yield fell 10 bps to 7.96% — this is the first time since June 2013 that it has fallen below the policy repo rate. Needless to say, the market is now looking at the first rate cut from the RBI under governor Rajan in the next policy review in February 2015, if not before.
The signal that monetary easing is now in the offing was not entirely expected by the markets until three months ago. While some believed RBI will have no room to ease monetary policy in 2015 due to stickiness in CPI inflation, others expected it to actually hike rates as the CPI inflation target of 6% for January 2016 would not be met. As highlighted in my previous columns, both concerns have proved to be misplaced.
The tough policy medicine administered by both the RBI and the government since July 2013 has started to have a noticeable impact on the economy. On the inflation front, let me highlight two key trends observed over the last 12 months:
- Core inflation, within CPI, has fallen from 8.1% to 5.9%
- Food inflation, within CPI, has fallen from 12.4% to 5.8%
While moderation in core inflation is clearly a result of RBI’s tight monetary policy and ongoing gradual fiscal consolidation, the sharp fall in food inflation despite irregular rainfall, is largely a manifestation of an improvement in administrative policies (like moderate increase in MSPs, timely liquidation of buffer stock, crackdown on illegal hoarding, etc).
The sharp fall in international crude oil prices in the last two months has had a minor impact on CPI inflation so far. However, continued softness in crude prices will improve the inflation outlook substantially through food economy linkages and the expectations channel. In fact, the RBI’s downward revision in CPI forecasts for March 2015 (by 180 bps) and January 2016 (by 100 bps) should be read in this context.
With comfort emerging on the attainment of the inflation target, the RBI has now guided market expectations towards a change in monetary policy stance. With the debate on the ‘commencement’ of monetary easing now over, the market will now start focusing on the ‘extent’ of monetary easing.
Factors like monsoon performance in 2015, durability of softness in global commodity prices, government steps towards incremental fiscal consolidation with focus on quality of adjustment, debottlenecking of supply side concerns in infrastructure and agriculture would be key in deciding the extent of monetary easing from the RBI.
Uncertainty with respect to the positive shock from oil prices and the normalisation of interest rate trajectory in the US and the UK in 2015 will limit RBI’s room for maneuverability. However, with expected policy synergy from the government’s side, we anticipate a cumulative interest rate cut of 75 bps during the course of 2015.
By Shubhada Rao
The writer is senior president & chief economist, Yes Bank