Our base has the RBI MPC following Governor Das into another ‘out-of-box’ 35bps cut (followed by 15bps in December, and if global growth weakens, 40bps by September.) Why 50bps now?
By Indranil Sen Gupta & Aastha Gudwani
We believe there is a rising case for a 50bps RBI rate cut on October 4, with August inflation coming in at a lower-than-expected 3.2% on September 13. Core inflation (except gold) is a reasonable 4%. We track September inflation at 3.6%—well within RBI’s 4-6% mandate—on higher agflation. Our base has the RBI MPC following Governor Das into another ‘out-of-box’ 35bps cut (followed by 15bps in December, and if global growth weakens, 40bps by September.) Why 50bps now?
Lower yields/lending rates hold key to growth bottoming out by early 2020. The liquidity crunch is still hurting growth, with our India Activity Indicator pointing to weakness for another quarter. Further, time for lending rate cuts (50bps BofAMLe by March, 25bps FYTD) is running out with the October-March ‘busy’ industrial season around the corner. Transmission should be faster with banks linking 50% of their book to an external benchmark. Finally, we plan to review our RBI rate call after the September 18 FOMC meeting (25bps cut BofAMLe). It remains to be seen how banks re-price their lending rate on SME and retail loans on October 1.
Incoming data support our standing call of a benign inflation outlook, though October-February may be higher on adverse base effects. August CPI inflation came in at a low 3.2% (3.3% consensus, 3.5% BofAMLe), up from 3.15% in July (see graphic). Adjusted for food, fuel and gold, core inflation moderated to 4.02% from 4.07% in July (see graphic). Looking forward, we track 3.6% for September on continued rise in food prices. A pick up in sowing on revival of rains should limit agflation ahead, in our view (see graphic). July industrial growth posted a higher-than-expected 4.3%, up from 1.2% in June (2.5% BofAMLe, consensus). This, in our view, is too volatile to call. Manufacturing did the heavy-lifting. While capital goods continued to contract, core IIP growth pushed headline up. FYTD IIP growth, at 3.3%, is running below FY19’s 3.9%.
We see the RBI MPC cutting to a 4.5% RBI repo rate by September 2020, if global growth weakens. This will hold the real rate, 1.9% now, at 0-1% ex post and (-)1.5% ex ante. In the early 2000s recession, Governor Jalan had cut to 4.5%, 50bps below the 5% WPI average. As real lending rates are higher, a more negative real policy rate is surely justified, in CPI terms, especially as CPI inflation averages 100bps above WPI. Second, we assess that further RBI rate cuts are necessary to bring real lending rates down to our estimated 7% potential (in old GDP series) to incentivise investment. Finally, differential between the US federal funds rate target and RBI rate will still be a comfortable 300bps, even with our 75bps Fed cut.
How will the introduction of external benchmarks, effective October 1, impact the RBI MPC’s rate policy? Our base case has banks pricing fresh retail/SME loans on a spread defined as the difference between the current retail/SME lending rate and the external benchmark. As the external benchmark falls on RBI rate cuts, banks will duly reduce lending rates. What if banks settle at a lower spread/lending rate to begin with? This would obviously reduce the need for deeper RBI rate cuts. Edited excerpts from BofAML’s 3.2% Aug CPI: Rising case for 50bp RBI rate cut, Oct 4 (September 13, 2019)
(Sen Gupta is Chief India economist , and Gudwani is India economist, BofA Merrill Lynch. Views are personal)