Markets believe a rate cut today is a foregone conclusion, with some even calling for a 50 bps cut. We think it’s a much closer call, and while we expect RBI to cut rates by 25 bps today, we also expect the central bank will strike a much more cautious tone, pointing to rising inflation risks that limit the space for further easing.
On the face of it, this may seem oxymoronic: a dovish action but hawkish guidance? But, we believe, it reflects the different cross-currents at play, wherein both growth and inflation risks have increased over the last month—notwithstanding last week’s buoyant GDP report—that have placed the central bank in a delicate position.
Prima facie, with GDP growth accelerating to 7.5% in the January-March quarter, expectations of a rate cut might appear outlandish. But there are mitigating factors at play. Growth on the ground is perceived to be much weaker than the GDP numbers suggest. For starters, we believe GDP estimated on the production side is more representative of activity in Q1. And here the story is far more sobering. Growth in gross value-added terms actually moderated to 6.1% in Q1-15 oya from 6.8% in Q4-14 and 8.4% oya in Q2-14.
In other words, the anticipated boost to growth from the positive supply shock of collapsing oil prices has not materialised. If anything, growth has slowed, weighted down by the rural economy, fiscal tightening, sluggish global growth over the last two quarters, and a dormant capex cycle. GDP data apart, the tell-tale signs are everywhere. Q1 sales growth—for listed firms in the MSCI India Index—contracted by 8% and was the lowest in 22 quarters. Similarly, earnings growth (adjusted for one-offs and exceptional factors, to better reflect operating earnings) contracted 8% in Q1-15 and was also the lowest in 22 quarters, despite the sharp fall in input costs over the last six months. Imagine, where we would be if oil was at $115!
Simultaneously, core inflation has fallen faster than had been expected, pushing up real interest rates perhaps more than had been envisioned. And the 36-country real effective exchange rate has appreciated by almost 10% since the start of 2014. All this has meant that monetary conditions have tightened meaningfully over the last year (see chart). We would argue this has been important to generate the disinflation over the last few months. But given where growth is currently perceived to be, the current level of the MCI may seem tight vis-a-vis its relationship with growth in the mid-2000s. All this would argue for some easing at today’s review, and forms the basis for our 25 bps call.
A final reason to move now would be opportunistic timing: to ease as far ahead as possible from a Fed lift-off later this year that could make any easing—while not impossible—more challenging.
But even as growth risks have risen, so have some inflation risks. One can argue that weaker growth bodes well for the core inflation outlook. True, but risks to food and fuel inflation have increased since the last RBI review. Oil prices have rallied 10% since the last review, though, at current levels, are likely not enough to disturb the 6% inflation target for January 2015.
The real upside risk, therefore, emanates from a spike in food inflation. And here the monsoon is the elephant in the room. Back in April, in its first forecast, the Met had predicted a 68% chance of a sub-normal monsoon. And the US National Weather Service has indicated a 90% chance of El Nino conditions persisting. But there are mitigating factors on both counts. For starters, as we have earlier indicated, the Met’s first forecast is equivalent to the toss of a coin, with the first forecast being right only half the time over the last decade.
But the risk of El Nino is very real. Here. policy-makers can perhaps draw comfort from the fact that the translation from an El Nino to a drought in India is by no means automatic. As we have previously indicated, over the last 25 years, there have been nine El Nino events, but only four have translated into a drought. That said, the translation over the last decade has been much higher with three of the four El Ninos resulting in a drought, though it’s too early to tell whether this simply reflects noise in the data or a structural break in the relationship.
So even though the risks of a weak monsoon have arisen, it is too early to presume that outcome. More importantly, the policy response—in the event of a bad monsoon—will be of equal importance. Recall, the country suffered a deficient monsoon last year (88% of normal), but food inflation actually moderated on the back of effective government interventions (sale of rice and wheat from the buffer stocks, imports of oilseeds and pulses, and measures to reduce hoarding and ease supply bottlenecks of fruits and vegetables). So, if RBI has growing confidence in the government’s ability to act quickly and decisively, the Met’s first forecast of a sub-par monsoon is not necessarily a deal-breaker for a rate cut.
But the larger message should not be lost. Inflation risks have risen in the last few months. Oil prices are 40% higher than their lows in January, we are getting closer to a Fed exit that could pressure emerging market currencies, and the monsoon could again play spoiler. Add to these risks the central bank’s desire to keep real rates between 1.5-2%—which, we believe, is absolutely essential to re-intermediating household savings into financial assets and thereby domestically finance any investment pick-up—and the space for significant monetary policy easing from here just does not exist. Growth impulses will need to be created from sustained supply-side reforms, that drives non-inflationary growth. The sooner markets appreciate this simple fact, the better.
The author is Chief India Economist, JP Morgan