Focus on inflation prompts status quo despite recent growth jitters
The Monetary Policy Committee (MPC) decided to leave the repo rate unchanged at 6% and retain its neutral stance in the fourth policy review for FY2018, whilst appreciably paring its baseline growth forecast.
Providing no major surprises, the committee reiterated its focus on guarding against risks to achieving the medium-term inflation target of 4%, thereby reinforcing its independence.
The status quo followed from the rapid uptick in CPI inflation to 3.4% in August 2017 from the series-low 1.5% in June 2017, which coincided with mounting global geopolitical uncertainty and financial market volatility.
In line with our expectation, the decision to keep the repo rate unchanged was not unanimous, with one member voting for a reduction of 25 basis points (bps), highlighting the variation in individual members’ prognosis of the inflation-growth dynamics.
The MPC now expects inflation to range between 4.2-4.6% in H2 FY2018, including the impact of the revision in house rent allowance (HRA) by the central government, suggesting that the retention of the neutral stance in Wednesday’s policy review is justified, despite the recent growth jitters.
In addition, farm loan waivers and pay revision at the state level could impart further upside risks to the inflation trajectory.
Similar to the last policy resolution, the MPC specifically highlighted that state-level pay revision has not been factored into its baseline inflation projections. It indicated that a magnitude of increase equivalent to the revision undertaken by the central government could push inflation above the baseline estimate by as much as 100 bps over a time period of 18-24 months. The rather hawkish outlook resulted in a modest hardening of bond yields after the policy announcement.
In our view, receding vegetable prices and the recent cut in central excise duty on petrol and diesel by Rs2/litre would douse inflationary pressures to some extent, and cause CPI inflation to plateau in September-October 2017.
However, an uptrend would resume in the subsequent months, on account of factors such as the decline in output of most kharif crops forecast by the First Advance Estimates for Crop Production, the as-yet incomplete pass-through of the goods and services tax (GST) to final prices of various goods and services, the staggered impact of HRA revision on housing inflation, and an unfavourable base effect. The MPC reduced its baseline forecast for GVA growth for FY2018 to 6.7% from 7.3%, prompted by the subdued print for Q1 FY2018, the estimated kharif output, and the adverse impact of the transition to GST on production schedules, cautioning further that the latter may delay a revival in investment activity.
Moreover, rising input costs and weak pricing power may erode corporate margins, which would dampen GVA growth for the industrial sector.
The MPC also highlighted the need to adequately recapitalise public sector banks to ensure ample flow of credit to the productive sectors. However, the committee emphasized that recently introduced structural reforms are likely to boost growth over the medium term, by improving the business environment, augmenting transparency and prompting a formalisation of the economy.
Furthermore, it suggested higher infrastructure spending, restarting stalled projects, improvements in the ease of doing business including simplification of GST, and swifter implementation of affordable housing, as possible remedies to the prevailing growth slowdown.
We concur with the MPC’s revised growth forecast for FY2018. Data for various formal sectors for August 2017 provides some evidence of a reversal, albeit patchy, of the transitory slowdown in volume growth observed during the transition to the GST.
Moreover, a back-ended pickup in spending by the state governments and a favourable base effect are likely to contribute to higher GVA growth in the remaining quarters of FY2018, from the muted 5.6% in Q1 FY2018.
Benefitting from muted inflation in H1 FY2018, the average CPI inflation for this fiscal is likely to be well-below 4%, suggesting some scope for further monetary easing. However, the expected uptrend in inflation during H2 FY2018 may remain a sticking point.
On balance, the scope for rate cuts this year would be restricted to 25 bps, which would materialize only if the inflation trajectory significantly undershoots expectations.
Aditi Nayar is principal economist at Icra Ltd.