The Reserve Bank of India’s (RBI) policy actions were in line with my expectations. After a gap of nine months, RBI cut the repo rate by 25 basis points (bps). For the third time in four policy reviews, RBI also cut cash reserve ratio, or portion of deposits that banks need to keep with the central bank, by 25 bps. One basis point is 0.01 percentage point. RBI justified these actions on account of the need to arrest the loss of growth momentum and the space offered by moderation in both the wholesale price index (WPI)-based inflation and core inflation that excludes food and fuel prices that tend to be volatile.
The central bank has taken comfort from the WPI index slowing over the last three months. Note that consensus inflation estimates were also on the higher side and this led to interest rate markets correctly pricing in some policy easing in the current quarter, in line with RBI’s guidance late last year. What is interesting is that RBI has also made a bold judgement call that core inflation will remain subdued in the months ahead despite the potential rise in administered prices as the government tries to cut fuel and fertilizer subsidies. While RBI has not committed itself to big rate cuts down the line, it has left the door open should headline inflation surprise on the downside.
Although the recent inflation trajectory has been comforting, I think there are reasons to be cautious on the outlook for prices. First, it is not clear whether the recent decline in manufacturing as well as non-food manufacturing inflation will be sustained. Based on a disaggregated analysis of the WPI, it appears that the provisional inflation figures over the last two months could be under-stating actual inflation because of a poor response rate by respondents. Typically, such aberrations get corrected at the turn of the calendar year or the financial year. Secondly, the way diesel and cooking gas price have been implemented has led to some ambiguity on how these prices will be captured in WPI. It could be that WPI may end up underestimating inflation despite higher prices of administered fuels. Lastly, the second-round effects of these hikes should not be doubted if, as the consensus goes, the economy has bottomed out. Further, when RBI is engaged in easing policy and banks have promised to ensure transmission, some pass-through of higher fuel prices can be expected, particularly at the retail level. This may lead to further divergence between the wholesale and retail level inflation rates, which could result in the perverse situation of inflation expectations rising even as RBI is cutting interest rates.
All said, given that WPI inflation may average around 7% over the next 12 months, I don’t see much scope for further policy easing. It is likely that RBI will cut the repo rate by another 25 bps before it takes a long pause. From a policy transmission perspective, it may make sense for RBI to effect that 25 bps cut in the March review itself rather than wait for the May annual policy. That way, the annual policy can be used as a tool to facilitate credit growth by cutting the statutory liquidity ratio and the HTM (held-to-maturity) limit for government securities. Lastly, as an aside, Tuesday’s policy decision as well as the justification used, raises the question about the role of core inflation in policymaking. In my understanding, core inflation is relevant because it helps identify the underlying inflation trends. Such a supposition is valid only when headline and core inflation trends converge over the forecast horizon. However, if like in India, persistent structural factors restrain such convergence, then the use of core inflation for guiding policy decisions should be questioned. Or the choice of core inflation should be more rigorous. In my view, RBI will be well served if they explore use of statistical measures such as trimmed mean inflation to assess the underlying trend. Similarly, the role of the current account deficit (CAD) in policy making continues to be a grey area despite RBI flagging off the risk. Given that the deterioration in CAD is primarily due to high gold imports, there is an argument that India is not suffering from worsening competitiveness but rather disguised capital outflows. Such a conclusion, while debatable, will have more stark implications for macro policy.
A. Prasanna, chief economist, ICICI Securities Primary Dealership