Given the growth recovery and cyclical rise in inflation that both we and the Reserve Bank of India (RBI) are projecting, we don’t expect the RBI to take up any further easing measures. This has been supported by the recent MPC statement and accompanying Monetary Policy Report, which highlighted that CPI inflation would remain above 4% (the centre of the central bank’s target band) throughout the forecast horizon, suggesting little room for further easing. We thus expect the RBI to maintain its neutral stance for longer. However, as the economy evolves in line with our narrative of a broadening recovery and rising headline inflation, we think that the RBI will gradually shift towards a hawkish tone, eventually paving the way for a rate hike in the second half of fiscal 2019. Our expectation for the central bank to move towards a rate hike cycle is predicated on the view that inflation will rise over the forecast horizon as the cyclical recovery takes hold. With improving capacity utilisation and a narrowing of the output gap over time, the inflation trajectory should be on an upward path, and the upside risks should begin to build. Against this backdrop and given the MPC’s commitment to the inflation target, the central bank will need to act to ensure that inflation expectations are anchored and that the actual inflation outcomes do not deviate too far from the 4% target.
In addition to the rise in inflation, we see two other factors supporting the start of the rate hike cycle. First, with the economy undergoing a full-fledged recovery with domestic private capex picking up, the level of neutral real rates would have likely picked up from the 150-200bp range that the central bank indicated earlier in the cycle. External factors in the form of the Fed taking its interest rates higher over the course of the forecast horizon would be an additional factor to consider. Over our forecast horizon through the end of calendar 2019, we pencil in a benign rate hike cycle, expecting the central bank to begin hiking rates by the second half of fiscal 2019, with a total of three rate hikes expected by the end of calendar 2019.
Fiscal policy – a pause in consolidation
In recent months, there have been heightened concerns about the trend in the fiscal deficit and, more generally, about the commitment to staying on a path of fiscal consolidation (which has been a key driver in the improvement in macro stability since 2014). These concerns have risen against the backdrop of the sluggish GDP growth print in the Jun-17 quarter (and the attendant debate on whether policy makers would stimulate the economy via fiscal deficit expansion) and states’ widening fiscal deficit due initially to the UDAY bonds in previous years and subsequent pressures from state farm loan waivers this year.
To add to the uncertainty, this is happening at a time when India is about to head into General Elections in May 2019 and when investors are already anticipating a pre-election fiscal boost. Considering the backdrop, in particular the elections in May 2019, we expect policy makers to take a pause on fiscal consolidation in FY19, before resuming the path in FY20. At a consolidated (Centre plus states) level, we expect the fiscal deficit to narrow from 6.9% in FY17 to 6.4% in FY18 and to be maintained at 6.4% in FY19. Specifically, we expect the central government’s fiscal deficit to be 3.3% of GDP in FY19 and the states’ deficit to be 3.1% of GDP.
Extracted from Morgan Stanley India Economic Outlook report