While macroeconomic effects of an expansionary fiscal policy (for few states) would be inflationary in nature (in the medium term), the manifestation of these risks could be contingent upon timeline and manner of rollout
The last few RBI monetary policies have been contemplative. In a dynamic environment, where both inflation and growth trajectories have been repeatedly surprising (both on the downside), monetary policy decisions and their prediction has kept the market experts prognostic. In a similar vein, ahead of the third bi-monthly monetary policy review, enough compelling reasons were floating for RBI to ‘Act’ (read 25 bps cut) or ‘Not act’; with a small section of market also advocating for an ‘Aggressive action’ (read 50 bps cut!). The commitment of RBI’s Monetary Policy Committee to keep headline inflation close to 4% on a durable basis, and its perceived risks to inflation formed the basis for these different opinions. But as we are now aware, the MPC delivered a 25 bps rate cut, with the judgment being driven by three
* CPI inflation retreating below the downwardly revised inflation range of 2.0-3.5% for H1 FY18 to a record low of 1.54% in Jun-17, as upside risks to inflation did not materialise owing to benign global commodity prices and a weak seasonal momentum, amidst a favourable base
* Core inflation, which excludes volatile components of food and fuel, easing by close to 100 bps since the beginning of FY18 to 3.9% as of Jun-17, after having been extremely sticky around 4.8% over the last 12 months
* A normal and well-distributed south-west monsoon, ending the month of July in a 2% surplus (as a % of LPA)
Despite the rate cut and reiteration of its neutral stance, concerns remain on factors that could potentially be inflationary in nature. On the foreseeable horizon, while RBI has indicated upside risks from the recently announced allowances hike under 7th CPC and MSPs for kharif crops, we expect the impact of both to remain manageable at close to 40 bps on a cumulative basis. Other potential inflation risks are anticipated from states’ spending uplift led in part by hikes in salary and allowances under Pay Commission obligations. While macroeconomic effects of an expansionary fiscal policy (for few states) would be inflationary in nature (in the medium term), the manifestation of these risks could be contingent upon timeline and manner of rollout.
As such, our assessment of inflation trajectory for FY18 is sanguine, with average CPI inflation expected to drift lower by 100 bps to 3.5% in FY18 (from 4.5% in FY17) on the back of pricing power remaining subdued amidst persistence of negative output gap. This comfort on inflation, we think, could potentially allow RBI to deliver one final 25 bps rate cut before the end of this year. Upside in structural inflation pressures thereafter accompanied by MPCs vigil to maintain the 4.0% inflation target, will restrain any further rate reductions. However, risks to our call remain from any sharper than anticipated reversal in price of perishables and its second order impact in the economy, and global developments inducing heightened financial market volatility especially with respect to Fed unwinding its balance sheet.
The author is group president & chief economist, YES Bank