We expect Reserve Bank of India (RBI) governor Raghuram Rajan to pause on 30 September to await further clarity about inflation peaking off. Our first cut is pencilled for February. In our view, the battle against inflation is won, although it is but natural that RBI wants to be sure after so great a sacrifice in terms of growth. Governor Rajan has himself said he will not hold rates high longer than necessary. It will be time, next year, to nurse a recovery by cutting rates.

We believe that Consumer Price Index (CPI)-based inflation will subside to RBI’s 8% January 2015 and 6% January 2016 targets, if rains are normal. Looking beyond fluctuations in the monsoon, rising agriculture investment is actually dousing structural inflation. Second, “imported" inflation is waning with the US Federal Reserve (Fed) tapering containing commodity prices and RBI’s accretion to foreign exchange reserves stabilizing the rupee. On our part, we expect RBI to buy another $35-40 billion by March 2016 to maintain the current import cover. This should hold the rupee around 60 per dollar. Finally, weak aggregate demand restrains pricing power. While we believe that growth will bottom out to 6.5% next fiscal, it is not until 2018 that it will cross the estimated 7.5% potential to pressure inflation. Governor Rajan has himself said that “…it is not that we have to touch 6% (inflation) to cut interest rates, but have to project 6% (inflation) to cut rates…"

We expect Rajan to hold on 30 September and December to await clarity about inflation peaking off. Although inflation will likely dip to 6% in November, this will be on the base effect of last year’s spike. Given the noise, it will be difficult for RBI to distinguish between what is underlying and what is due to base effects in the inflation slowdown.

What changes by February? RBI will likely get the comfort of meeting its 8% January CPI inflation target. Fed tapering and June rate hike expectations should hold oil prices in check. Even if dated Brent climbs to, say, $108 barrel, the pass-through to domestic diesel prices will likely be complete by June. Finally, late rains should have watered good winter rabi sowing. Near-normal water levels in the Bhakra, Pong and Thien dams augur well for the coming wheat crop.

Can RBI really cut in February if the Fed hikes in June as we expect? Yes, if it is able to build up foreign exchange reserves to comfort investor confidence. The rate differential, at 800 basis points (bps), is already far higher than the average 460 bps since January 2003. (A basis point is one-hundredth of a percentage point.) Second, it is really high foreign exchange reserves rather than the rate differential that holds the key to rupee stability. High import cover allowed for a sustainable appreciation of the rupee during 2006-08, although the rate differential on an average was a mere 180 bps. Rising rate differentials could not prevent depreciation during 2011-13 as the import cover halved to seven months. Finally, the Fed tightening will likely contain “imported" inflation by stabilizing commodity prices. In fact, we are already seeing expectations of lower global liquidity stabilizing global commodity prices.

We continue to believe that cuts in the statutory liquidity ratio (SLR) will not lead to and, in fact, delay lending rate cuts. Bank prime lending rates have been typically marked 400 bps above, say, the riskless 10-year government bond yield. SLR cuts that push up the riskless rate will keep the 10-year yield high as banks will be reluctant to cut the risk premium when asset quality is in question. At the same time, we are not overtly concerned about the recent drop in credit offtake as it is largely driven by base effects of the temporary shift to bank loans from commercial paper after commercial paper rates spiked after the July 2013 tightening measures.

The writer is India economist at Bank of America Merril Lynch. This is the third and last in a series of articles ahead of RBI’s monetary policy review on 30 September.

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