RBI monetary policy: Staying with a pause
As the Reserve Bank of India (RBI) goes into the last policy meeting of 2017, it is imperative to draw on the discussions of the Monetary Policy Committee (MPC) at its last meeting. The committee had noted that inflation has changed course over July and August after reaching its floor of 1.5% in June. This was a reason why the majority of MPC members voted to keep the policy rate unchanged, given the objective of RBI to keep the target of 4% inflation within “striking distance”. The risks to future inflation were seen emanating from factors such as firming international crude oil prices, increased financial market volatility, fiscal issues, etc. Issues pertaining to growth were discussed and the broad conclusion was that even as the output gap was negative, data was not adequate to segregate the transitory and structural factors behind the slowdown.
The incremental information that RBI has after it met on 4 October is the following. After staying flat in September at 3.3%, headline Consumer Price Index (CPI)-based inflation has moved higher to 3.6% in October and is broadly expected to climb closer to 4% in November. Core retail inflation ex-fuel and light and ex-paan/tobacco has remained steady at around 4.4-4.5%. Headline Wholesale Price Index-based inflation has moved up to 3.6% in October from 2.6% in September. Importantly, Brent crude price was at around $56/barrel in the beginning of October and is now trading at around $63/barrel, an increase of over 12% in this period. Similarly, prices of other commodities including base metals have been going up. While some benefit can be derived from an appreciation bias of the rupee, there is a sense of an overall pressure for the manufacturing side from the input cost perspective and this could lead to higher core retail inflation in the future.
Reflecting a higher risk to future inflation, RBI has already upped its inflation forecast to 4.2-4.6% for the remainder of FY18 (from an earlier range of 4-4.5%). Importantly, RBI projects headline CPI inflation to rise to 4.9% in Q3FY19. With this trajectory in mind, there appears a very limited scope for the central bank to reduce interest rates immediately. Various economic agents might continue to argue for a softer monetary policy on the basis that private investments are not picking up and there is a need for impetus from RBI as real rates appear too high. However, we do not think that RBI will be buying into this argument as growth is expected to have revived in Q2FY18. Further, if headline CPI inflation is expected to move up to a 4.5% zone over the medium term (we expect headline CPI inflation to average at around 4.6-4.8% in FY19), the real rate that we are talking of is only around 1.5%, considering the current repo rate of 6%.
Importantly, even as growth recovers, it is unclear that there is better clarity on the growth dynamics compared to the assessment by RBI in October. Goods and services tax-related implications on growth could still be lingering as the new tax regime stabilizes. Early indicators of growth remain mixed with certain sectors doing better than others. On-ground reality is that private sector capacity utilization remains low at around 72-74% and further doses of interest rate cuts will not guarantee credit growth and private sector investments. The government has announced a bank recapitalization plan and there is some hope that banking sector credit will pick up, especially to the small and medium segments of manufacturing.
In my opinion, RBI is likely to stay cautious on developments in the global scenario. In the event that crude oil prices continue to stick at current levels, the current account deficit is likely to widen to around 2.4% of gross domestic product in FY19. There could also be implications for the revenues for the central government going forward as it might have to further reduce the excise collections on petro-products to prevent any sharp pass-through of higher prices to the end users. Further, the Union budget in February 2018 will be the last full budget for the current government as we head into the next elections in 2019. The fiscal strategy adopted by the centre will be of crucial importance and needs to be watched for some populist measures, dependent on the outcomes of the forthcoming state elections. Further, state government budgets are under some stress and this could continue if states themselves implement their own pay commission recommendations and more states announce farm loan waivers.
The verdict: RBI will keep its finger on the pause button not only in December but till March 2018. Beyond that, evolving economic data is likely to determine the course of policy interest rates in India, where the bias for a further reduction may not be too strong.
Indranil Pan is group chief economist at IDFC Bank Ltd. The views expressed are personal.
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