RBI October policy review: It would be worthwhile to introspect if further rate cuts would translate to higher growth readily.
By Suvodeep Rakshit
The Monetary Policy Committee (MPC) heads into the October 3-4 meeting with some ominous signs: a slightly adverse growth-inflation dynamics, tightening of the US Fed balance sheet, and rising commodity prices, specifically crude prices. The August policy rate cut was, in some sense, to adjust for the lower-than-estimated inflation trajectory. Going into the October policy, even as growth concerns have started coming to the fore (though growth has been weak for quite some time), it will be a tough call for the RBI to ease further in the face of the current conditions. We expect the RBI to pause in this policy and take stock of the various transient factors underway in the economy.
Even as the RBI has shifted to a flexible inflation-targeting framework with a target range of 2-6% on the headline inflation, over the past couple of quarters the target has been anchored around the 4% mark. The ‘noise’ around the growth slowdown over the last few weeks complicates the RBI problem as a compelling case will be built to support growth. It is possible that the RBI will sharply revise its FY2018 GVA growth estimate lower to a range of 6.5-6.8%. We have been skeptical on India’s growth prospect for the past few quarters and continue to estimate GVA growth at 6.8% with a downward bias.
Much of the discussion within the RBI and MPC will likely be around the growth-inflation dynamics. We note that core GVA growth (GVA excluding agriculture, and government expenditure related components) has slowed down over the past five quarters. In effect, government expenditure was pulling up growth in the past quarters. Given the uncertainty around GST revenue collections along with around Rs300 bn lower surplus transfer from the RBI, the ability of the government to prop up growth seems severely constraint without large slippages on the fiscal deficit front.
However, it will be important to note that the economy has seen a significant supply shock, especially through the MSME segment with disruptions emanating from both demonetization and GST implementation. Within the MPC, expectedly, there will be a split as some would vote for reducing rates to offset for lower growth. It would be worthwhile to introspect if further rate cuts would translate to higher growth readily. Growth has been slowing down as a combined effect of (1) balance sheet tightening, (2) demonetization-led hit on certain sectors, and (3) GST-led impact on the enterprises, especially the MSMEs—none of which can actually change through rate cuts.
In face of a supply-side shock, pump-priming the demand side with fiscal “stimulus” or through large rate cuts is unlikely to be a solution. It will possibly be a gradual recovery with a requirement to have select focus on certain segments such as housing, job creation in public services, rural employment and income, and capacity creation for long term growth. While inaction may not seem as an option, knee-jerk reaction is definitely not an option either. Macroeconomic stability is always hard-earned and the markets should pay heed to past failures (in the long term) of policy prescriptions advocating profligacy.
The inflation trajectory will continue to move up based on (1) higher food inflation, (2) housing inflation due to 7CPC HRA impact, and (3) to some extent due to higher fuel prices. As per the first advance estimates, kharif foodgrains production is marginally lower than last year. A better sense of the output-prices dynamics will emerge in November/December when the harvest arrives at the markets. The inflation levels may not seem alarming as of now as we expect headline CPI inflation to move to around 4.7% by March 2018. However, this will need to be seen in conjunction with balance sheet adjustment by the Fed (albeit gradually), higher crude prices, and a much expected INR depreciation. Compared to the August policy, GVA growth has continued to be on the same path as earlier, headline inflation has picked up, crude prices are higher by around US$5-6/bbl, global rates have hardened, and the INR has depreciated by around 1.5% against the USD since last policy. It would be worthwhile to be on a wait-and-watch mode for the October policy, maintain prudence, and defer further decision based on incremental data.
(The author is Vice-President and Senior Economist at Kotak Institutional Equities)