RBI’s new normal
We’ve said this before. And we have found new evidence since. Inflation in India has slowed dramatically, and while the excessively low levels of the last few months may not be maintained, if the inflation rate bounces back up, it is unlikely to do so by much.
We ignore the temporary noise surrounding inflation, and instead, focus on the underlying momentum. There are three good reasons why the Reserve Bank of India (RBI) target of 4% may have already become the new normal for inflation in India.
First, the so-called differential between India’s inflation and that of the rest of the world is returning to its more normal historical level. The gap over the long term is actually close to 2 percentage points, but between 2008 and 2013, it rose to over 5 percentage points. Many commentators assume the latter to be the normal, when in fact it was an abnormal episode in India’s inflation history (see chart above).
Thankfully, the factors that caused it have been reversed. For instance, the minimum support prices for agricultural produce have been kept within a relatively tight range and global commodity prices have been subdued.
What this suggests is that India’s inflation differential may well be getting back to pre-2008 levels and that domestic inflation could remain below 4.5% over the next few years.
Second, various measures of inflation expectations have been moderating and have now entered a virtuous cycle in which falling inflation each year is triggering even lower inflation in the next. This, by our estimate, could anchor India’s inflation rate at the 4% target, provided it does not get hit by a massive outside shock, for example a rapid rise in oil prices.
The chances are good that this virtuous cycle will last long, given that it is associated with powerful structural changes such as the introduction of the inflation-targeting policy. Two-thirds of emerging market economies that adopted the policy were comfortably able to lower inflation rates to the target ballpark by the fourth year of doing so. The fourth year, in India’s case, happens to be 2017!
Third, the “resting point” for food prices could be low. A confluence of factors has pushed food inflation into negative terrain. Some are temporary, such as a bumper crop after two years of drought and rampant destocking in the wake of demonetization and the goods and services tax. Others will last, for instance, food distribution reforms. These include more efficient open market operations in releasing foodgrains from state granaries, allowing farmers to bypass the state machinery and sell fresh produce directly in the markets, importing shortfall items such as pulses and edible oils and clamping down on hoarders.
When we take out the temporary factors and quantify the impact of long-lasting food reforms, we find food inflation resting at 4%. With food inflation at 4%, core inflation hovering around the same (as is the case now) and oil prices under $65 a barrel, it is likely that headline inflation will rest at around 4%.
What does all this mean for interest rates?
If RBI were a purist “inflation targeter”, there would be no space for rate cuts (or hikes) if, as we argue, inflation is already at 4%. Zero rate cuts would then be the lower end of the “possibility range”.On the other hand, RBI has often spoken about “real rates” (the policy repo rate minus the one-year-ahead inflation forecast). Let’s for a moment assume RBI is a real rates targeter rather than an inflation targeter and has a preference for keeping real rates at 1.5%, which is where it was for much of 2015 and 2016. Marrying our longer-term inflation forecast of 4% with real rates of 1.5% suggests that the RBI’s repo rate could be cut by 75 basis points. This, then, becomes the other end of the “possibility range”. One basis point is one-hundredth of a percentage point.
The truth is that RBI is not a real rates targeter and has a natural preference to be on the lower half of the rate cut “possibility range”. In addition, RBI has recently spoken about its tolerance for higher real rates. In the June monetary policy committee (MPC) minutes, deputy governor Viral Acharya said that “tolerance for a slightly higher real rate of interest is justified to ensure weak banks do not find relatively low the hurdle rate for ever-greening bad loans ...”.
All considered, we expect RBI to cut the policy repo rate by 25 basis points to 6% on 2 August. A final 25 basis point rate cut later in the year could be possible, but only if consumer price index inflation continues to sharply undershoot the 4% target in the second half of FY18. Things might be even better than we think (on the inflation front) but we need to tread carefully (with rate cuts) if we want to preserve the gains.
Pranjul Bhandari is chief India economist at HSBC.
This is the last of three columns in the run up to RBI’s third bi-monthly monetary policy statement for 2017-18 on 2 August.