The January monetary policy is coming at a time when inflation is finally showing some signs of sustained moderation after three long years. The cumulative 90 basis point (bps) fall in wholesale price inflation for three successive months defied expectations of an uptick in December by the Reserve Bank of India (RBI). A basis point is one-hundredth of a percentage point.
Also, a sharp fall in core inflation, which excludes food and fuel prices, to 4.2% year-on-year in December (the lowest since March 2010) from 5.73% in September should be music to RBI’s ears. Relatively stable global commodity prices, range-bound exchange-rate movements and weaker domestic demand explain this fall in core inflation.
If this positive momentum continues, March inflation is likely to be much lower than RBI’s projection of 7.5% from a year ago. In fact, we think it could even be slightly lower than 7% even after accounting for the recent fuel price increases. In our view, the declining inflationary trend, coupled with RBI’s guidance of shifting the policy focus from inflation to growth, should pave the way for a 25 bps repo rate cut in the January policy, the first after the 50 bps rate cut in April 2012.
While inflation is falling, the dilemma before the central bank is that the level of inflation is still much higher than its stated comfort zone of about 5%. Even with benign global commodity price forecasts, the wholesale price index (WPI) is unlikely to reach that comfort level in the next one year.
RBI governor D. Subbarao seems to have indicated this challenge when in a recent speech he mentioned that there was limited scope for monetary stimulus since the level of inflation is still very high.
His emphasis on the level of inflation rather than the trend in inflation practically ruled out a 50 bps rate cut in January, which some market participants were expecting.
Also, there is very little comfort to be drawn from the December consumer price index (CPI) inflation of 10.56%, which was sharply higher than November’s 9.9% reading. The WPI-CPI divergence is largely caused by food (it has a greater weight in the CPI than WPI) and house prices (which are not included in the WPI). The December CPI print is distorted by statistical base effects, but RBI is unlikely to ignore it completely. After all, inflation expectations might be shaped more by CPI than WPI. The extremely high current account deficit of 5.4% of gross domestic product (GDP) in the second quarter of the current fiscal also points towards a gradual rather than a radical approach to monetary easing.
In the past, RBI made monetary easing conditional on government moves towards fiscal consolidation. The government’s recent steps to stem expenditure and reduce subsidies are encouraging. These measures might not have a large impact on the FY13 fiscal deficit but build the foundation for a better FY14 number. The space created by tighter fiscal policy can encourage a relatively easier monetary policy.
The short-term inflationary impact of these administrative price changes should be less of a concern for the central bank. In fact, the diesel price increase in September hardly had any second-round impact on manufacturing or food inflation through cascading effects. This is an indication of declining pricing power in an economy where the demand side is slowing.
According to our baseline inflation forecast, average inflation for FY14 should decline by about 100 bps to 6.5% even after accounting for moderate increase in administered prices of fuel products and electricity. Acknowledging this declining trend, it is possible for RBI to cut policy rates by an equivalent amount throughout the course of the year.
However, the declining trend in inflation is more prominent until Q2 FY14 and hence the rate cuts might be somewhat front-loaded. The extent of rate cuts will also depend on how quickly demand side inflationary pressures start reappearing following an easier monetary policy. We do not expect a cut in the cash reserve ratio (CRR), or the proportion of deposits that commercial banks must keep with RBI, but a widening gap between credit and deposit rates might indicate a structural liquidity deficit if it persists longer.
Samiran Chakraborty is Regional head of Research, South Asia of Standard Chartered Plc.
The Reserve Bank of India will unveil its quarterly monetary policy on 29 January amid widespread expectations of a rate cut as well as a cut in banks’ cash reserve ratio to prop up investment demand in a slowing economy. This is second of a series of articles, written by well-known economists, in the run up to the policy.