RBI will likely monitor the inflation trajectory closely before cutting rates further
The Reserve Bank of India (RBI) will likely leave the key policy interest rates unchanged next week. Since the RBI’s previous policy meeting in June, both retail (CPI) and wholesale (WPI) inflation have surprised on the upside, while global uncertainties enhanced further, primarily owing to Britain’s decision to leave the European Union.
Against the backdrop of such developments and given that RBI now seems to have relatively few “rate cut bullets" left in the current cycle (150 basis point repo rate cuts since January 2015), the central bank will likely stay on hold in August and will likely monitor the inflation trajectory closely before cutting rates further.
As regards the commentary, the central bank can still maintain a cautiously accommodative policy stance. The broad macroeconomic backdrop—a generally benign inflation trajectory (despite the upside surprise during Q2 2016), only a gradual recovery in economic activity, and a disciplined fiscal stance—remains conducive for a broadly accommodative policy stance. Demand-driven pressure on inflation remains limited. Better food price management, sustained idle industrial capacity, and the renewed softening in global commodity prices, augur well for inflation by and large staying anchored in the coming months. The progress of monsoon—currently 1% above normal, with over 80% of the country receiving normal to excess rainfall—and sowing of summer crops (+6% y/y) are encouraging. Although the rupee is likely to weaken against the dollar during 2016, it is not expected to materially alter the otherwise well-anchored inflation trajectory. The recent upside surprise in inflation was driven largely by food prices, primarily volatile food items. Typically, inflation driven by more volatile food items such as vegetables and fruits tends to start self-correcting relatively quickly; a good monsoon might help as well, albeit likely with some lag. Overall, I see a strong possibility of material softening in retail inflation during H2 2016, with likely multiple sub-5% readings. Accordingly, I expect another 25 basis point repo rate cut in Q4 2016 taking the repo rate to 6.25% by end-2016.
Since its announcement of easing of liquidity stance in the April meeting, the RBI has injected over ₹ 80,000 crore into the banking system through open market operations (OMO) involving purchases of bonds. This has led to significant easing of banking system liquidity. However, the central bank is expected to largely maintain its liquidity supporting stance in the coming months as and when required. Indeed, currently it is equally important to focus on the RBI’s liquidity supporting measures rather than narrowly focusing only on rate action. Separately, while Governor Rajan is set to leave RBI in September, we do not expect any abrupt change in RBI’s monetary policy framework of “flexible inflation targeting". We also expect the central bank to continue with the process of formalising a monetary policy committee in the coming months.
While the global backdrop is challenging, India’s domestic macro-fundamentals remain on a stronger footing. India’s 7.6% real gross domestic product (GDP) growth in 2015-16 was helped by broadly supportive consumption demand, while investment activity still remains in a soft patch, relying heavily on public spending amid weak private capex. Persisting weakness in private capex underscores the need for supportive public policy in the near to medium term. We expect recovery in economic activity to stay gradual, and potentially uneven—our baseline scenario is that of a real GDP growth of 7.7% in 2016-17. India remains relatively less impacted by the Brexit-related uncertainties. While India’s trade links with the UK and euro area are meaningful, they are relatively less significant in the context of GDP growth, given the dominance of domestic factors in the case of the Indian economy. But in the context of economic activities, one must note the sizeable ‘grey’ areas still persisting under the new methodology of India’s national income accounting; we feel there is an upside bias in growth estimates under the new series. Under the old methodology, we think India’s 2016-17 GDP growth rate would have been around the mid-6% mark, lower than its trend growth rate. Given this, the ‘new’ growth prints need to be interpreted carefully; seemingly high headline GDP growth shouldn’t be seen as an obstacle to maintaining a prolonged accommodative monetary policy stance by RBI.
Siddhartha Sanyal is chief India economist, Barclays Capital.