GST impact and sliding food prices due to a good monsoon will make sure inflation stays low in the near future
The monetary policy committee (MPC) decided to retain policy repo rate at 6.25%. However, the best thing is that there was divergent opinion in terms of rate setting, with one of the members possibly in favour of a rate cut. This means that, finally, the MPC have crossed the hallowed wisdom of unanimity of the last four policy meetings. Interestingly, when it comes to MPC, the US voting is a case in point. Alan Greenspan chaired the FOMC for over 18 years and was never on the losing side of a vote, and on paper, FOMC always reached decisions by majority vote. Full marks to MPC for this spilt verdict so early! RBI also clearly acknowledged that its inflation forecasting exercise was wide off the mark. The first half inflation forecast now stands at 2-3.5% (4-4.4.5% in April) and 4-4.5% in second half (4.5-5% in April). It is perplexing how the inflation forecasting could go so wrong/need to be corrected within two months. We reiterate that inflation forecasting based on assumptions that are static in nature (oil prices, government spending, etc) is unlikely to result in correct estimates for RBI in the near future too. It is high time that RBI guides the market with a short-term inflation outlook so that the financial markets are better prepared in terms of predictive uncertainties.
We also express concern that rushing towards the 4% inflation-targeting could actually complicate matters in terms of output-inflation trade-off. For example, RBI, in a working paper by Mitra, Biswas and Sanyal (2015), has estimated the sacrifice ratios (cumulative output and employment losses arising from a permanent reduction of inflation) liberalisation period for India. They found that the sacrifice ratio estimates have been found to be increasing from September 2001, continuing till June 2004, before descending rapidly till September 2005. The sacrifice ratio estimate is found to be stable in the range of 2.0-2.2 from September 2005 to September 2008 (prior to crisis). During the global crisis, the sacrifice ratio has increased gradually till June 2010 and remain in the range of 2.2-2.9. After June 2010, the sacrifice ratio moderated and remained in the range of 2-3%. The present situation of declining inflation is akin to the September 2004-August 2008 period, when sacrifice ratio was 2.3%. So, we expect the present sacrifice ratio is closer to 2.3%, if not higher. This is definitely not a low number by developing-country standards.
Meanwhile, to give further flexibility to banks to comply with LCR, RBI has slashed SLR by 50 bps (to 20%) with effect from June 24, 2017. In the fourth Bi-Monthly Monetary Policy Statement 2015-16 on September 29, 2015, RBI had given the roadmap to reduce SLR by 25 bps every quarter till March 31, 2017. In line with the path, SLR has reached 20.5% as on January 7, 2017, from 21.25% in April 2, 2016. The surplus system liquidity and low credit growth has pushed banks to hold around 6-7% excess SLR; so, this cut will not benefit banks. Assuming the deposit growth is around 10% for the next one year, this will release additional funds to the tune of Rs 5,000 crore. However, once credit starts to pick up, this may help banks manage their liquidity situation.
Second, as a countercyclical measure, RBI reduced the risk weight for individual housing loans of select category. Now, home loan between Rs 30 lakh and Rs 75 lakh (with LTV>75 and = 80) will attract will attract risk weight of 35% instead of 50%, and loans above Rs 75 lakh (with LTV = 75) will attract risk weight of 50% instead of 75%. The standard asset provision also been reduced to 0.25% from 0.40%. A well-known example of countercyclical measures are those seen during September 2004 to August 2008, when risk weights and provisioning prescriptions were tightened periodically. Our research suggests that RBI move will release capital of only around Rs 500 crore for the entire banking industry. RBI could have brought down risk weights for entire loan categories (and also in the less-than Rs 30 lakh) as this would have given a definite push to the affordable housing segment that is so crucial to job creation. Clearly, the policy may be thus just a little bit half-hearted!
Finally, we believe that most inflation risks are now on the downside. In fact, a comparison of food prices over the last three years indicate that food prices are now lower than the average and prices are not just mean reverting, but mean reversing. Additionally, GST implementation’s impact on CPI would be more than 10 bps in the downward direction. Internationally, contrary to popular perception, inflation has declined in countries post GST. In fact, for the statistically-minded, in the first six days of monsoon 2017, actual rainfall is already 5% above normal. Also, with oil prices capped on the downside, and inflation likely at 2% or even less in coming months, it will be now difficult for RBI to hold rates for long now!