Rate cut: RBI may not oblige

It is natural for the new government to focus on recovery through a turnaround in investment spending and business sentiment. For this to materialize, the support of the Reserve Bank of India (RBI) will be sought to complement its growth agenda by relaxing the tight policy stance. The central bank is unlikely to oblige. We expect RBI will keep the benchmark repo rate unchanged at 8% at the early-June review.

Not for nothing will RBI governor Raghuram Rajan stand his ground and assert institutional independence. Firstly, even though retail inflation has eased from 9.5% in 2013-14 to 8.6% in April, the latter marks a rebound from the recent bottom in February’s 8%. It is premature to interpret the slight downtick in the April core consumer-price inflation to 7.8% as weakening price momentum.

Barring the unexpected, inflation should continue towards the 8% target by early-2015 and to 6% a year later. But the path is unlikely to be linear.

Apart from base effects, the trajectory faces risks from unseasonal weather and the likelihood of a weak southwest monsoon on the back of an El Nino weather phenomenon in the September quarter. A complete deregulation of retail fuel prices and overhaul of the administered prices could also pose short-term risks. The direction of the rupee and commodity prices add further uncertainty.

Rate cuts in this environment could damage the Reserve bank’s credibility and dilute its inflation-fighting stance. The governor has assured that transient factors and base effects that influence inflation will not be acted upon. With this in mind, we expect the central bank will keep rates on hold this fiscal year.

A separate objective of deposit mobilization is important as well, as real rates are on the cusp of turning positive after nearly two years.

Secondly, growth momentum is bottoming out after a prolonged period of slowing. The strong mandate handed to the new government fuels optimism that the economy’s growth drivers will shift from consumption to investment-based recovery. With this gradual turnaround in sight, the compression in the output gap also argues for an anti-inflationary stance.

Finally, the fiscal objectives of the incoming government will influence the monetary policy stance. The upcoming budget will shed light on the preference towards subsidies, tax regime, development spending, divestment and the overall fiscal consolidation agenda. Admittedly, it will be difficult to lower the budget deficit this year, as a sudden retracement on welfare and social spending allocations could backfire on the new administration.

Instead, some fine-tuning by way of sticking with the diesel price deregulation, along with a roadmap over a gradual reduction in fertilizer and food handouts could bring some relief. Despite the efforts, a realistic set of economic assumptions might leave the fiscal deficit higher than the indicative 4.1% of gross domestic product (GDP). To balance the accommodative fiscal stance, RBI needs to maintain a tight policy stance.

So far, the central bank has been fighting the inflation battle alone and to some extent has had to counter the accommodative fiscal stance of the government. Hence it is important to align fiscal and monetary policies to ensure that neither party dilutes the efforts of the other. This will require the incoming government to engage in constructive discussions with the central bank to lay out the priorities and help iron out the cost-push pressures. Areas that require the government’s attention include better foodgrain storage facilities, review of minimum support prices and excess foodgrain stocks and ease infrastructure bottlenecks. In short, measures that focus on increasing longer-run supply while holding short-run demand in check will be helpful on the inflationary front. RBI can reciprocate by providing funds on preferential terms for infrastructure projects and other long-term obligations.

This is the first in a series of three articles ahead of RBI’s policy review on 3 June.