From a monetary policy perspective, the year 2015 began on a promising note.
From a monetary policy perspective, the year 2015 began on a promising note. With significant disinflation in CPI, expectations ran high with respect to the degree of monetary easing that was in store. In fact since January, the Reserve Bank of India eased repo rate by a cumulative of 75 bps, including the 25-bps cut in the June policy review.
Despite the delivery of the anticipated monetary easing in June policy review, the markets posted a disappointing performance with the Nifty falling by 2.3% and 10-year government security yield rising by 8 bps. Unlike previous episodes, the absence of a dovish tone (read: guidance on future rate cuts) in the latest policy came across as a near-term reality check for the markets. The upward revision by the RBI to its January CPI inflation estimate to approximately 6% — the same as the targeted level — was perceived as a case for no more rate cuts in the future.
The RBI offered three key risks as a justification for the moderate upward shift in its anticipated inflation trajectory: (1) possibility of a deficiency in south-west monsoon basis preliminary forecast by various weather agencies; (2) firming up of oil prices and associated geopolitical risks; and (3) volatility in external environment.
There is nothing new on these ‘known unknown’ risks. They were on the table even at the time of April policy review.
Let’s take a step further on each of them.
(1) South-West monsoon deficiency is a necessary but not a sufficient condition for food inflation getting out of control. This is something which even the RBI admits as per their recent study “Monsoon and Indian Agriculture – Conjoined or Decoupled”. Efficient administrative response towards ensuring smooth supply, rationalisation of minimum support prices, and prudential liquidation of buffer stock successfully attenuated the risk from monsoon shock in 2014 when overall outturn was just 88% of the long-term average.
(2) Oil prices have indeed firmed up significantly from their January lows of $45 pb levels on account of geopolitical risks, sharp drop in US rig counts, some weakness in dollar, etc. However, despite the recent run-up, prices are very closely tracking RBI’s assumed level of $60-63 pb levels for FY16. The near-term price outlook appears ranged, especially with the expectation of OPEC once again keeping production targets unchanged at its upcoming meeting later this month.
(3) Notwithstanding the volatility in global fixed income markets in April-May, the anticipated timing of Fed lift-off is gradually getting pushed back with soft US economic data. The market is now expecting just one 25-bps rate hike from the Fed in 2015 vis-à-vis 50 bps just 2-3 months ago. This is likely to keep volatility associated with the monetary policy normalisation suppressed in the near term.
These known unknown event risks have the potential to disrupt the inflation trajectory. In fact, if all of these play out during the course of FY16, then CPI inflation could be significantly higher than 6% in January. However, they are exogenous in nature and all of them will also set in motion some self correcting mechanisms. To elaborate:
(1) A la 2014, the government will get proactive on food management and depressed rural incomes will put downward pressure on core inflation
(2) while a global riskoff environment will leave rupee weaker, a stronger dollar in the meantime will tend to depress oil prices.
Under these circumstances, it’s good to be agnostic while waiting for the event to unfold. This is precisely what the RBI tried to communicate. Some of these risks could very well diminish during the course of the year depending upon policy responses. This could potentially open up room for one more round of rate cut by the RBI. For the time-being, a near-term pause is the most prudent policy response.
The writer is Senior President & Chief Economist at YES Bank