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Business News/ Opinion / Is RBI better placed now?
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Is RBI better placed now?

There should not be any discomfort from RBI on the Union budget as it has continued with a path of fiscal consolidation, yet attempting to boost capital expenditure

RBI had articulated that its next target for retail inflation is the 4%—the middle of the inflation corridor that has been set up for the Monetary Policy Committee to follow. Photo: Pradeep Gaur/MintPremium
RBI had articulated that its next target for retail inflation is the 4%—the middle of the inflation corridor that has been set up for the Monetary Policy Committee to follow. Photo: Pradeep Gaur/Mint

In the last two policy meetings, the Reserve Bank of India (RBI) surprised the market. When there was no expectation of a rate cut in October, RBI delivered one. Later, in the backdrop of sustained fall in headline consumer price index (CPI) inflation and the demonetisation-linked erosion in growth, the market had expected the RBI to cut the repo rate by 25 bps in December. But then, RBI held back. The December decision could have been determined more by external factors than internal dynamics. The US Fed rate decision of December was impending and it was broadly expected that interest rates in US were likely to go up, especially with Donald Trump as the president-elect and his pre-election rhetoric of pushing growth with fiscal openness. This was expected to boost the dollar and consequently, put pressure for the emerging market (EM) currencies to depreciate—a difficult situation for any EM central bank to signal a softer monetary policy. Further, RBI assessed that there could be upside risks to inflation, not only from the currency depreciation but also as oil prices and other commodity prices were firming up globally.

To understand the scope for RBI at its February policy to reduce rate, we need to understand the economic landscape of today—not only the domestic dynamics but also the global perspective. In December, the world was waiting for the start of the Trump era and the influence of his policies on the US economy and the likely geopolitical developments. True to his pre-election rhetoric, Trump has now pulled out of the Trans Pacific Partnership and is clearly guiding towards a more protectionist world. As a consequence, the dollar is weakening, contrary to earlier anticipation of a firming dollar. This has also led to the rupee to strengthen closer to 67.25 than pushing beyond 68. This should lead to the RBI breathing easier, but it is unlikely to forget the global risks, especially in the context of a changing global political landscape.

Domestic headline inflation prints have continued to surprise on the downside over the last few months. Post RBI’s December meeting, we were witness to two further retail inflation readings. The reading for November was at 3.63% and that for December surprised even lower at 3.41%. The principal reason was lower food prices—especially that of vegetables and pulses. Part of the explanation for this drop could be seasonal while the other part of the explanation is based on the demonetisation effect that prevented perishables to be lifted from the farm gate due to cash shortage. Consequent to these readings, the expectation for the average CPI for Q4 of FY17 is now 3.8%, significantly lower than the RBI’s stated expectation of 5%. This probably could be the best argument from the domestic perspective for the RBI to cut repo rate by a further 25 bps.

However, RBI could maintain some caution in its arguments on inflation. While the retail inflation has come down drawing comfort from food inflation, core inflation has stayed extremely sticky and has averaged at 4.75% in the financial year till date. Incidentally, this is higher than the 4.51% average core inflation witnessed in FY2016, and there does not appear much chance of this coming down. On the food side, cereal and protein prices have maintained its steady trend. Thus, the underlying belief is that as the vegetable and pulses prices steady out and as the base effect for inflation is removed, there is every chance for headline retail inflation to crawl back to levels higher than 4%. And this is the crucial assessment that the RBI will have to make. In this context, RBI had articulated that its next target for retail inflation is the 4%—the middle of the inflation corridor that has been set up for the Monetary Policy Committee (MPC) to follow.

There should not be any discomfort from RBI on the Union budget as it has continued with a path of fiscal consolidation, yet attempting to boost capital expenditure. On the growth front, the Economic Survey and the Union budget seem to argue that the implications of demonetisation would be only transitory. However, credit growth has slumped sharply and is being expected to remain weak for some time.

From the above, it is apparent that the choice would be a very difficult one for RBI. If the MPC assesses that there is a necessity of an easier policy to lift domestic growth as there is comfort from the inflation side, then they should cut repo immediately than wait it out. My personal bias would be for a last 25bps rate cut and hence favour RBI to move in this direction now, rather than later.

Indranil Pan is the chief economist at IDFC Bank Ltd. The views expressed above are personal.

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Published: 05 Feb 2017, 11:51 PM IST
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