Making the case for an RBI rate cut
With the government now delivering on the anticipated direction of fiscal adjustment for FY18, the markets have now turned their attention towards the upcoming monetary policy review on 8 February. After the Reserve Bank of India (RBI) stayed pat against the consensus expectation of a 25 basis point (bps) cut in its December policy review, the rate cut expectation got immediately repositioned for the next policy review in February. With signs of prudence, rectitude and discipline displayed by the FY18 Union budget, such expectations of monetary policy easing have gained further currency.
However, if one were to extrapolate the Monetary Policy Committee’s (MPC’s) December policy stance, then it leaves a sense of disquiet. Two factors that weighed on the policy decision in favour of status quo were:
• increase in global commodity prices
• tightening of global financial conditions
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Both these factors continue to receive much policy attention. Market forecasts for crude oil in 2017 have inched closer to $60 per barrel levels from an average price of $44 per barrel in 2016. The US Federal Reserve, after raising the policy rate by 25 bps in December, projected a higher-than-anticipated trajectory of a 75 bps cumulative hike for 2017. These could raise external sector risks, leading to a potential build-up of imported inflation. However, these risks are likely to be moderate, with oil price increase contributing about 20 bps to retail inflation and strength in foreign direct investment (FDI) inflows ensuring stable financing of the current account deficit.
Moreover, with FY17 approaching its end, a few MPC members have highlighted the need to start focusing on the mid-point of the government’s notified medium-term inflation target of 4% (plus or minus 2%). This could significantly reduce the degree of freedom with respect to policy discretion on incremental monetary easing.
Could the RBI then endorse consensus?
Despite the above mentioned risks, there could still be room to ease monetary policy. Consider the following:
1. Let’s look at the policy anchor, consumer price index (CPI) inflation. From an average level of 4.9% in FY16, CPI inflation is now poised to moderate towards 4.6% in FY17. Although the central bank projected March 2017 CPI inflation at 5%, the same as its target for the current financial year, there is a strong likelihood of actual inflation undershooting the target by a significant margin of 60-80 bps.
The story behind moderating CPI inflation is not just restricted to food. In fact, demand side pressures have also been moderating as reflected in the core-core inflation trend (4.8% during Apr-Dec FY17 vis-à-vis 5.4% in the corresponding period in FY16).
2. While there could be some near-term upside pressure on inflation from implementation of the 7th Central Pay Commission (CPC) allowances and goods and services tax (GST) in FY18, the policymakers should, in my opinion, be ignoring them as both can be construed as technical impacts. Moreover, the former is unlikely to result in second-order impact via spillovers, especially post demonetization and the drive towards better tax compliance. The latter is a structural reform, which, post adjustment effects in FY18, is widely expected to lower inflationary pressures in the medium term.
3. According to the recently presented Economic Survey, the impact of demonetization on FY17 gross domestic product (GDP) growth is likely to be around 25-50 bps, greater than RBI’s estimate of 15-20 bps provided in the December policy review. This could continue to keep pricing power at subdued levels in the near future.
4. There are many fascinating aspects about the fiscal policy (for both FY17 and FY18). Despite the burden of one rank one pay (OROP) and the 7th CPC, the government has been able to tighten the headline fiscal balance by 0.7% of GDP over the two year period. Considering that past pay commissions had willy-nilly led to deterioration in the government’s fiscal health, this stands out as an impressive achievement. This could serve as a model for replication in fiscal management for state governments who would be implementing their pay commissions over the next one to two years. However, this is not where the story ends.
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(i)The government has been mindful of the need to preserve the quality of fiscal adjustment. According to revised estimates, capital expenditure for FY17 is now expected to be higher (10.6% growth) than what was budgeted initially (3.9% growth). For FY18, capital expenditure is expected to follow a similar trend of 10.7% growth. This would be greater than the budgeted revenue expenditure growth of 5.9% for FY18.
(ii) Allocation for subsidies at 1.6% of GDP would be the lowest in nine years.
(iii) For FY18, by budgeting for a revenue deficit of 1.9% of GDP, the government will outperform its Fiscal Responsibility and Budget Management (FRBM) target of 2%.
(iv) Primary deficit is now on the verge of getting eliminated. The FY18 target of 0.1% of GDP for primary deficit would be the lowest in a decade.
5. There has been significant acceleration in monetary policy transmission, with most banks reducing their marginal cost of funds-based lending rate (MCLR) by 75-100 bps since the beginning of demonetization. This is expected to be viewed favourably by RBI.
With global financial and commodity markets now stabilizing, on balance, I believe there is a prima facie case for a 25 bps rate cut in February. With inflation remaining benign, delaying monetary accommodation at this stage could disproportionately increase the sacrifice ratio for the economy.
Shubhada Rao is chief economist at Yes Bank Ltd.