BackFocus back on fiscal rectitude
Every fiscal year, the third bi-monthly monetary policy has monsoon as the key swing factor for rate action
Premium
With the Reserve Bank of India (RBI) keeping the repo rate steady at 6.5% while reiterating its commitment to an accommodative monetary policy stance, the next thing that will have a bearing on macroeconomic stability and monetary policy is the fiscal stance, for which the Fiscal Reform and Budget Management Committee has been set up.
The government has reaffirmed its pursuit of maintaining a stable macroeconomic environment by ratifying the inflation target at 4% plus or minus two percentage points for the next five years. The ball, thus, is in the government’s court once again, and it needs to retain the fiscal stance that complements monetary policy. This will ensure that the gains made on the fiscal and monetary fronts over the last two years are not reversed.
As for spiking food price inflation, with the monsoon and crop sowing progressing well, it should be tempered in the months ahead and can create the elbow room for another rate cut later this year.
That will probably be the last one in this cycle, which began in January 2015 and has led to a 150 basis point reduction in the repo rate. It could happen as early as in October.
The story thereafter will depend on how effective rate transmission is rather than on fresh rate cuts.
Every fiscal year, the third bi-monthly monetary policy has monsoon as the key swing factor for rate action. A rewind to the August 2015 policy shows that concerns over inadequate monsoon rainfall had constrained RBI, and rightly so because of sub-normal rainfall the year ended with. However, despite the poor monsoon, average consumer inflation in fiscal year 2016 was a touch below 5%.
Surprises around inflation have become the norm rather than exception. With idiosyncratic factors driving food inflation (with a weight of over 40% in Consumer Price Index), this is bound to happen. Assessing whether the spike in inflation is due to transitory or durable factors will keep challenging Indian policy makers.
In June 2016 the spike in food inflation lifted retail inflation closer to the upper bound of the flexible inflation target of 2-6%. While food inflation increased to 7.4% in June, core inflation moderated by 20 basis points to 5%, signalling tepid demand conditions.
We believe inflation is likely to head down to an average 5% this fiscal year due to the following factors:
First, the spike in food inflation appears to be transitory, largely a legacy effect of two consecutive poor monsoons with unirrigated crops such as pulses being the key driver. Our analysis of pulses inflation over the past decade shows that pulses inflation spikes every third year and comes down sharply with the supply response kicking in.
This year, the supply response will be driven by a good monsoon and imports. Rains so far have been 3.4% above normal and the less irrigated parts of the country—Madhya Pradesh, Rajasthan, Maharashtra, Andhra Pradesh and Karnataka—which account for 70% of pulses production in India, have received good rains.
The sown area for pulses till 5 August was 35% higher than last year. Additionally, the decision to import pulses this year should help tamp down prices.
With normal rains, other items of the food basket should also see softer prices.
Second, local factors have turned favourable from an inflation perspective. For example, with the risk of Brexit playing out and global growth getting marked down, commodity and crude oil prices will continue to remain soft. Also, advanced countries are now leaning even more on an easy monetary policy. Europe, Japan and the UK continue to press the monetary accelerator and the US Federal Reserve has slowed down rate hikes. This also creates some elbow room for RBI to cut the repo rate.
Third, the seventh pay commission hikes are unlikely to have any noticeable inflationary impact, given the small quantum of increase in an excess-capacity environment.
Attaining the mid-point of the range—4%— would be a tough ask without structurally fixing the agricultural ecosystem. Proactive policy measures including a prudent fiscal policy will help, though.
Dharmakirti Joshi is chief economist at Crisil Ratings.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!
