RBI: Neutral over dovish
The Reserve Bank of India monetary policy committee left the benchmark rate unchanged at 6%, in line with expectations. In the coming weeks, the debate on what the central bank will do (keep rates on hold) versus what it ought to do (cut rates) is bound to continue.
Wednesday’s neutral tone, however, reinforces our view that the bar for rate cuts is high. RBI reinforced its inflation focus by narrowing its inflation projection for 2HFY18 to 4.2 to 4.6% from wider 4-4.5% earlier. Its growth estimate was slashed to 6.7% from 7.3%. To gauge the need for a policy response, RBI needs to ascertain the appropriate timing to stimulate the economy. For example, not long after the demonetization, RBI in December 2016 defied rate cut expectations and held rates. They argued that the negative impact on growth from demonetization would be transitory. When it lowered rates in August, it was in response to inflation breaching the lower end of the targeted 2-6% range.
Returning to the present, there are common threads to the above and Wednesday’s commentary. While RBI wants to ascertain the extent of the negative output gap, a look at the upmove in their quarterly growth projections (for rest of FY18) reflect how they interpret the ongoing slowdown. High-frequency numbers are also showing signs of revival, including auto sales, PMI-manufacturing, core industries index etc. We concur that growth is likely to have bottomed out at 5.7% year-on-year in the June quarter and might average 6-7% in 2HFY18. While full-year growth will still be at a three-year low, there is now less urgency to shift the gears lower. It will also buy the central bank more time to factor the shifting global developments, such as higher oil prices and rising interest rates, into domestic fiscal policy. The onus is back on the government to support growth, once the GST-led uncertainties wear off. Greater emphasis should be put on the recovery of non-performing assets and rebuilding banks’ balance sheets. In essence, further rate cuts are not seen as a panacea to support growth.
Fiscal developments will matter to the central bank. In most of the policy statements this year, policy committee members have cautioned against relaxing fiscal discipline. Farm loan waivers and approaching general elections in 2019 were highlighted as risks to the outlook. Recent developments have made the risk of fiscal slippage more real. Despite the recent speculation of a fiscal stimulus, the government has, to its credit, chosen to keep its powder dry. Two reasons were probably behind this. First, there is a need to strike a balance between growth and fiscal discipline. Second, more time is needed to assess downside risks to growth and revenue collections. While waters have calmed down, we still expect the budget to modestly miss its FY18 targets from a revenue shortfall. Tuesday’s decision to lower fuel excise duties will further impinge on collections, with potential loss at Rs13,000 crore (~0.1% of GDP). A less rigid deficit target will also reduce the extent to which spending needs to be compressed in 2HFY18. A final decision on the fiscal front is likely to be taken in November/December, closer to the last parliamentary session and ahead of the FY19 budget to be tabled in February. Last but not the least, the central bank’s mandate is maintaining price stability.
The RBI has, by narrowing its 2H inflation estimate to the higher end of its previous range, reinforced its commitment to contain second-round effects. This is conditional on growth bottoming and improving for the rest of the year. The government’s recent decision to marginally lower fuel excise duty should have a token impact on capping inflation provided that domestic fuel prices do not move higher in response to any increase in global prices. As long as it is adhering strictly to the inflation-targeting framework, the central bank has little wiggle room to revive growth without sacrificing some policy credibility. Should this become necessary amid above-target inflation, the central bank will need to resort to emphasizing the “flexibility” aspect of the framework in order to open the door for rate cuts.
Radhika Rao is an economist at DBS Bank.