RBI’s monetary policy and inflation: Steady as she goes is the theme
As 2017 draws to a close, global conditions appear favourable for 2018. With global gross domestic product (GDP) growth projected at a solid 3.6% in 2017, the International Monetary Fund (IMF) expects growth to pick up to 3.7% in 2018, the fastest pace in seven years. Labour markets have continued to tighten in developed economies, but inflation remains benign, which has allowed the process of monetary policy normalization to remain gradual. This Goldilocks view—not too hot, not too cold—has supported risk sentiment in emerging markets (EMs). A win-win for all.
Domestically, the twin disruptions of demonetisation and the goods and services tax (GST) caused India’s growth cycle to diverge from the synchronized global recovery. Barring a surge in September due to front-loaded shipments, GST-related disruptions have led to weak exports since May 2017, but this should change in the coming quarters.
The GST Council has made numerous modifications to ease tax compliance, minimize supply disruptions and stabilize the new GST regime, which should help the industrial sector to recover. Remonetisation is also ongoing, with M1 money supply growth rising to 8.5% year-on-year in mid-November 2017 from its low of -18.7% in end-December 2016, which will benefit cash-intensive services sectors. We think the reversal of these supply disruptions alone should trigger a cyclical recovery.
More importantly, the promised recapitalisation of public sector banks should set the stage for a more durable take-off in the next 12-18 months. This recapitalisation will help public sector banks (PSBs) write off bad loans and enable a deleveraging of balance-sheets. The availability of growth capital for on-lending by PSBs is also a big positive, as it should ensure a sufficient supply of funding for loans when the capital expenditure cycle turns. Thus, we expect India’s growth cycle to converge with the global growth cycle next year.
India’s inflation rate converged with global trends in 2017. The undershooting on consumer price index inflation was due to both demand- and supply-side factors. On the demand side, the weaker cyclical outlook led to disinflationary forces acting on core inflation. On the supply side, demonetization and excess production resulted in a sharp drop in prices of perishables (like vegetables and pulses). Some of this decline is likely transitory, but there are also durable factors at play including moderating inflation expectations and good food supply management.
This has been an “abnormal” year, with the Indian economy affected by the twin disruptions. Thus, where inflation will settle when the economy transitions to a more “normal” year is the critical question. The more durable drivers of disinflation should remain in place, but we see three risks on the horizon.
First, oil prices have inched higher, which have both direct and indirect impacts via higher transportation costs. Second, the sharp drop in food prices over the past year risks triggering an adverse supply response; a classic cobweb cycle where farmers switch away from crops that do not provide reasonable returns.
The drop in kharif production of pulses, oilseeds and jute and mesta is a red flag. Lastly, the rise in core inflation momentum since July reflects the inflationary effects of GST and the statistical impact of the higher house rent allowance, both of which will likely be looked at from a monetary policy perspective. However, there is a risk that the expected cyclical recovery ahead could increase the momentum of core inflation. Thus, while inflation should remain within the Reserve Bank of India’s target range (2-6%), it could easily flirt above the midpoint of its target (4%).
The other important consideration is the global monetary policy cycle. More central banks are likely to join the Fed-led normalization, including those in Asia; and balance sheet normalization by the Federal Reserve and the European Central Bank (ECB) will be in progress. The process could go smoothly, but EM central banks will need to stay on guard against capital outflow risks.
There are also downside risks that could materialize, including a longer-than-expected time frame for bad-loan resolution that holds up the capex cycle for much longer, inflation remaining around 4% due to structural factors or a sharper-than-expected slowdown in China, which would result in a moderation of global growth and commodity prices.
It is against this backdrop that the monetary policy committee (MPC) will be making decisions. Unlike many other EMs, India is in a comfortable starting position. By not overreacting to the inflation moderation this year, the MPC has kept a sufficient real interest rate buffer, even if some of the upside risks materialize. Thus, steady as she goes is the theme, but the Reserve Bank of India must remain vigilant.
Sonal Varma is managing director and chief India economist, Nomura.
This is the second in a series of articles in the run-up to the Reserve Bank of India’s bi-monthly monetary policy meeting on 6 December.
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