Have interest rates bottomed out? Going by the tenor of RBI commentary on Thursday, it would appear that way. To be sure, there may be no case for the repo rate to be hiked immediately. However, if inflation forecasts are vulnerable to upside risks as the central bank would have us believe they are, there is clearly no chance of any more monetary easing until these risks are out of the way. The central bank says inflation has been ‘quiescent’ since early February, when it last reviewed monetary policy; pertinently, it now projects a higher inflation in H1FY18, an average of 4.5%, up from the 4-4.5% projected earlier. For the second half of FY18, RBI sees inflation at 5%, higher than its previous forecast of 4.5-5%.
The expectations of higher inflation stem from a variety of factors. Apart from the chances of food prices rising more than anticipated in the event an El Nino impacts the monsoon and lowers the foodgrains output, the central bank is anxious that an increase in house rent allowances for government employees might push up the baseline trajectory by as much as 100-150 basis points over 12-18 months. A third risk could emanate from a one-time impact of GST—which could be rolled out in July—and a fourth from any spillover of the consolidated fisc that is already high. While it might seem the central bank is being overly conservative, it is not unjustified in red-flagging the deficit and the harm that loan waivers can do. This is a point the Union government needs to take cognisance of. Neither can RBI be blamed for being cautious, ahead of an unprecedented policy change like GST.
The upshot of the caution is that rate-cuts are ruled out till such time as inflationary pressures are well and truly bottled in. In other words, rates are likely to be on hold, probably for as long as the inflation outlook for a 12-14 month period is higher than 4-4.5%. Given how prices of crude oil have suddenly rebounded after easing in March, predicting price moves—amidst political unrest in West Asia —is tricky. Even at home, it is virtually impossible to visualise how food prices will behave, if there is an El Nino effect and to what extent the fatter house rent allowances will stoke a second-order rise in prices. The impact of the GST is even harder to assess. Most economists believe inflation would average closer to 5% in FY18.
However, some like Sonal Varma at Nomura have pointed out that the higher growth in rural wages coupled with a narrowing output gap and the adverse base effects could push inflation closer to 5.5-6% in H2FY18. Should inflation trend towards these levels, the central bank might even consider some tightening in 2018; Varma believes the risks are skewed towards a hike next year. Bond yields have spiked 17 basis points in two sessions, partly because of the supply of paper coming in, but also wary of RBI’s slightly more hawkish stance. A rate hike, even in 2018, would be most unfortunate. RBI’s forecast of a GVA of 7.4% for FY18 over 6.7% in FY17, seems a trifle optimistic especially given the potential disruption from the GST later in the year. Banks have started lowering loan rates—both the base rate and the MCLR—and it would be unfortunate if the rate cycle was to turn so quickly.