Inflation and output down, interest rates should follow
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Headline consumer price index (CPI) inflation fell sharply to 5.1% in August from 6.1% the previous month. This is driven by a strong low base last year (3.7%, August 2015) and lower prices of vegetables and pulses. The sharper fall was in industrial growth though. This plunged by 2.4% in July from 2% in June. Both outturns have surprised, defying respective consensus estimates of 5.2% and 1.5%. Industrial output has shrunk -0.2% in this year (April-July 2016) against corresponding growth of 3.5% last year.
The strong base effect is expected to combine with weakening food prices to push inflation further down into the sub-5% region by December. With this configuration, the output gap assumes more importance for monetary policy. The relevant question is the timing and extent of reduction in the policy rate—this would depend upon the balance of risks the Reserve Bank of India (RBI) sees to inflation and its assessment of the output gap, which remains a mystery.
Financial conditions are supportive of downward adjustments in bank lending rates nonetheless. As a result of RBI’s shift in liquidity support and global impulses, the benchmark 10-year bond yields have tumbled from their April-June highs of 7.46% to 7.14% last month. In September, the reference yield is ranging even lower at 7.04-7.06%. Yield movements will influence similar adjustments in the small savings interest rates. The next quarterly setting for these is due in October and with yields lower by about 40 basis points, administered interest rates will lower at least 25 basis points. The softening reference interest rates will induce automatic adjustments in the banks’ base rates, which now reflect the marginal cost of funds.
There is no reason why banks shouldn’t adjust their base rates. Apart from these chain effects, expected changes in the repo rate next quarter, either in October or December, will result in deposit and lending rates to soften some more. Therefore, the interest rate environment is likely to soften considerably.
This scenario is not altogether without any risks. The upcoming dollar repayments of FCNR deposits contracted in 2013 could affect liquidity and funding costs, for example, delaying interest rate adjustments. Food and oil prices could also surprise on the upside, overturning current assumptions. Core inflation is another issue—minus transport & communication segment, along with food and fuels, the sequential monthly momentum has been rising for the past three months. At 5.32%, this is above headline CPI inflation that is affected by volatile food price movements. Since the core inflation element reflects demand conditions, it remains to be seen what view the RBI takes in this regard. Last month for example, the central bank flagged the importance of its stickiness for future inflation dynamics.
Renu Kohli is a New Delhi based economist.