Given the ongoing growth-inflation dynamics, the possibility of one more cut in the repo rate beyond June cannot be ignored
After the two inter-meeting cuts in January and March, the Reserve Bank of India (RBI) kept its key policy interest rates unchanged at the April meeting. However, the central bank’s guidance remained dovish as RBI remains well on course to meet its 2016 Consumer Price Index (CPI) target of 6%. Inflation is set to stay low in the coming months; CPI will likely tread sub-4% in the third quarter of 2015.
On the other hand, on the growth front, India has witnessed only a gradual cyclical recovery and a notable uptick in the investment cycle looks less likely in 2015. On balance, one clearly expects another 25 basis point (bps) cut in the repo rate in the June policy, possibly with a slightly more cautious policy narrative. One basis point is one-hundredth of a percentage point.
Given the ongoing growth-inflation dynamics, the possibility of one more cut in the repo rate beyond June cannot be ignored. However, such an action will remain contingent upon greater clarity around a number of factors, including trends in commodity prices, the monsoon outcome, the likely 2016 inflation trajectory and the impact of a potential rate hike by the US Federal Reserve in the second half of 2015. Retail inflation in India will likely average 5% during 2015-16. But, at the same time, it may move up to 5.5-6% in early 2016 and, accordingly, RBI prefers to avoid cutting rates aggressively at the moment.
Pricing power and inflation expectations
The current softening in inflation remains broad-based, reflecting a host of factors such as better controls over food prices, persistent idle industrial capacity and a stable rupee. The April CPI came in at a benign sub-5% level despite unseasonal rains, a rise in the service tax rate and some hikes in domestic energy prices. While prices of commodities, especially oil, have moved up to an extent in recent weeks, we feel they are still materially favourable for India and the probability of a flare-up in commodity prices appears low.
Moreover, disinflation in India looks even stronger based on other inflation indicators (e.g., Wholesale Price Index, or WPI; gross domestic product deflator).
WPI-based inflation in April was about 750 basis points lower than the CPI. In fact, the WPI—which allocates a higher weight to industrial commodities and does not include services—has already contracted year-on-year for six consecutive months and is currently at a four-decade low. This reflects a material weakening in industrial pricing power. Household inflation expectations have dipped sharply since late 2014. RBI’s industrial surveys also show a considerable decline in raw material costs. Even with the modest improvements in growth, selling prices outlook have remained stagnant, and are unlikely to increase in the near future.
RBI, under governor Raghuram Rajan’s leadership, focuses primarily on the CPI for setting policy interest rates. Nevertheless, it will be neither easy nor prudent to ignore other indicators of inflation when divergences are so large and persisting for several months.
Longer-term inflation management
Also, some of the recent developments will likely help inflation management in the medium to long term. First, food inflation, despite sub-optimal weather conditions during the past year, has softened to around 6% from an average of more than 11% a year during the previous five years.
One feels that, among other things, the government’s stance of more active management of food stocks, allowing only a modest increase in minimum support prices (MSPs) of agro commodities, and stronger vigilance have played a major role in containing food inflation and inflation expectations. It might, thus, be fair to expect food inflation to, by and large, remain better anchored.
Second, the government seems mindful of fiscal discipline. While the February 2015 budget unveiled a slightly more relaxed fiscal consolidation path, the higher allocation for capital spending is a clear positive and will potentially boost long-term growth.
Third, the healthy balance of payment dynamics offers greater stability for the rupee and, thereby, will help contain imported inflation. Finally, the government continues to underscore its commitment to carry out reforms, even if unpopular, towards improving ease of doing business and long-term competitiveness of the country. While success on these fronts needs to be monitored on an ongoing basis, one sees more reasons to be hopeful than sceptical at the current juncture.
This is the last in a series of three articles ahead of RBI’s bimonthly monetary policy review on 2 June.