BackDeeper rate cuts may be needed, but will RBI deliver?
Given that RBI's primary objective is targeting CPI-based inflation below 5% by next year, the task becomes much more complicated
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The current growth-inflation mix in India is supportive of further monetary easing, but we do not expect the Reserve Bank of India (RBI) to cut rates before the announcement of the Union Budget in end-February. Even then, the 2 February monetary policy meeting will assume importance, as market participants will try to ascertain whether the central bank’s views about growth-inflation risks have changed materially since the last policy in December, in the backdrop of the ongoing global and domestic financial market developments.
We think a 25 basis points repo rate cut is a given in March or April, assuming the government will stick to its medium-term fiscal consolidation agenda. The more interesting question, however, is whether India needs more rate cuts beyond the 25 basis points easing that is already priced in by the markets, or more importantly, whether RBI will manage to find the necessary space to accommodate deeper rate cuts through 2016.
Based on the recent weak data on growth and subdued optimism reflected in different business surveys, a case can definitely be made for the need for a deeper monetary policy accommodation. It is not that deeper rate cuts will help boost private investment in a big way at this juncture of the business cycle. Private corporates in India, particularly the capital-intensive ones, are already under stress due to prior investment decisions having gone wrong (resulting in high leverage and low profitability) and are not keen to increase fresh capex spending, especially at a time when the global environment has become more uncertain. But lower interest rates will at least help the highly leveraged corporates to refinance their debt at a lower cost, which is a bigger priority for them at this juncture.
If RBI were to follow a multiple indicator approach of conducting monetary policy, it would have been easier for the central bank to justify deeper and faster rate cuts at this juncture of the business cycle, in our view. But given that RBI’s primary objective is targeting Consumer Price Index (CPI)-based inflation below 5% by next year, the task becomes much more complicated, especially given the various pipeline risks that could easily impact the inflation trajectory. Consider the following risks:
Food inflation: Food prices in India tend to be extremely volatile and could rise suddenly and sharply for a multitude of reasons (even under favourable weather conditions). Food items, which constitute nearly 50% of the CPI basket, will therefore continue to be a persistent risk and could easily derail RBI’s goal of achieving sub-5% CPI inflation.
Core inflation: Apart from risks to food inflation, the central bank will also have to deal with keeping core CPI inflation consistently in the range of 5-5.5%, if the headline CPI target of 5% is to be achieved next year. Apart from housing and clothing/footwear, core CPI primarily constitutes various items of services. The year-on-year inflation rate of most of these services is running above 5%, resulting in core CPI inflation having averaged 5.4% in 2015; the risk is that as growth recovery gains traction, the pressure on services inflation increases further, thereby making it difficult to contain core CPI inflation within the 5-5.5% range.
Inflation expectations: RBI has cut interest rates by 125 basis points in 2015, but private corporate sector has not shown much interest to invest in fresh capex. The rate cuts, however, will likely result in urban consumption picking up, as the lending rate cuts slowly start filtering into the economy. Add to that, the Seventh Pay Commission awards would help increase the disposable income of consumers, ceteris paribus, and likely provide a boost to private consumption growth. In the absence of a meaningful investment recovery, rising consumption growth could lead to an increase in inflation expectations and make the central bank’s target of achieving sub-5% inflation challenging.
The pipeline risks to inflation and RBI’s commitment to maintain a positive real interest rate in the range of 1.5-2% has led fixed income markets to rule out the possibility of deeper rate cuts in 2016, despite weak economic momentum. However, this expectation could change if the global economy tips into a recession, thereby delaying India’s growth recovery, which ultimately leads RBI to signal explicitly its comfort to conduct monetary policy with a lower real interest rate assumption (probably 1-1.5%). In such a scenario, if CPI inflation averages 5% in FY17, as we expect, then the terminal policy repo rate could come down to as low as 6% by the end of this year.
Kaushik Das is the India economist at Deutsche Bank. The views expressed are personal.
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