The Monetary Policy Committee outcome is awaited with some interest, since this is the first time a US FOMC type monetary policy review is undertaken. The fact that each individual member’s thinking underlying the decision will be published adds an additional dimension, allowing a multi-perspective view on the final outcome.
Current and expected financial and economic conditions suggest that there is a better than ever chance of a repo rate cut.
Financial conditions have eased significantly since the change in RBI’s liquidity framework from April 2016, with the benchmark overnight call rates staying within a narrow band of the repo rate. Current indications are that foreign currency inflows are likely to help support system liquidity. The US Fed’s hold decision, together with a more dovish tone, and a more cautious and conservative slant to the major central banks’ policy positions augurs a period of relative stability for financial markets.
China’s economic slowdown seems to have been arrested and chances are it will recover slowly. The OPEC decision to explore oil output cuts, while a bit negative for inflation prospects in India, will improve market perceptions of the emerging markets. All of this will help smooth India’s FCNR redemption process. Consequently, the rupee is likely to remain stable in the near term, with near term forward rates also having fallen.
The growth—inflation trade-off has probably become even more biased towards a continuation of an easing stance. Growth remains weak, although aggregate demand is likely to gradually improve, originating in the good monsoon fed agriculture sector and diffusing into the rural services ecosystem. The eight core sector data shows a mixed bag, with steel output rising sharply, but electricity, cement and other mineral production have been very weak. Capex will depend largely on public spending, but indications are that recovery will be gradual.
Bank credit off-take remains very muted, although the financial institutions, NBFCs and high rated corporates are accessing the corporate bond and commercial paper markets for their term loans and working capital needs.
The decision to cut the repo rate will hinge dominantly upon inflation. Over the next few months, CPI inflation is likely to drop, (to less than 4.5% in November 2016), and meet RBI’s forecast of 5% by March 2017, under some reasonable (see accompanying graph). These arise from a combination of falling vegetable prices and base effects, and RBI and most analysts will have a similar reading of the trends, with minor variations. Although the core CPI inflation has remained sticky, some part of this is due to the rise in prices of gold, silver and ornaments. These have a substantial weight of 31% in the personal care segment of the consumer index. The transport sub-index of the core CPI has also been quite volatile due to petrol and diesel price movements. Net of these components, even the core inflation levels seem to be gradually coming off.
The crucial factor for the MPC to decide on a rate cut, however, will be whether there exist structural factors consistent with a medium term alignment of inflation with the 4% target. And, it appears that there are. The government has been very conservative on hiking minimum support prices. Wage growth is unlikely to overheat in the near future, except in a few specialised segments. We expect that the average CPI inflation in FY18, one year from now, will be around 4.3%.
Indeed there are risks to this view. Inflation expectations have remained fairly sticky till March. If we add the effects of the Seventh Pay Commission recommended HRA increases, the initial effects of a reasonable GST standard rate, the progressive diffusion of the salary increases to state government employees and a slight rise in crude and commodities prices, we might see a 0.6-1.0% increase in the inflation rate over the base. However, some of this is likely to be a one-off rise, amenable to a see-through by RBI. Capacity utilisation remains low, inhibiting corporate pricing power.
How about the longer term? By RBI’s own metric, the neutral (interest) rate is the real one year ahead T-bill rate at around 1.5-2.0%, which has historically been about 0.35- 0.5% higher than the repo rate, implying a neutral real repo rate 1.15-1.5%. Given global dis-inflationary trends and weak aggregate demand conditions in India, the neutral rate is likely to be the lower band or less. The expected growth and inflation trajectories over the next few months might open up room for RBI to gradually cut the repo rate to around 6%.
The author is senior vice president and chief economist, Axis Bank.
Views are personal