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RBI has played down the REER (real effective exchange rate)-based overvaluation of the currency by stressing on the need to correct for productivity differentials. Photo: Mint
RBI has played down the REER (real effective exchange rate)-based overvaluation of the currency by stressing on the need to correct for productivity differentials. Photo: Mint

Central bank’s looking for more confirmation before further easing

On top of the inflation data, the budget is going to hold the key to future easing

The February monetary policy is indicating that the Reserve Bank of India (RBI) will prefer crossing the river by feeling the stones and wait for three key sets of economic data expected this month. The gross domestic product (GDP) data for 2014-15, the January Consumer Price Index (CPI) data with the new base year of 2011-12 and the budget at the end of the month are going to shape the direction of the timing and quantum of the future rate moves. Although there is no explicit mention of the possibility of an inter- meeting rate cut in this policy statement, RBI governor Raghuram Rajan has indicated in his post-policy interaction that this is not off the table and the general preconditions for further rate cuts remain the same as in the January statement. In fact, RBI has refrained from changing its GDP and inflation forecasts also, given the importance of the forthcoming data releases.

It is important to understand how RBI’s reaction function is going to be with respect to the three key data releases. To start with, the 2014-15 advance GDP release on 9 February might not have much bearing on the monetary policy stance. The re-based GDP growth numbers of last three years have raised more questions than answers. Even RBI has hinted that more analysis is needed to understand the GDP dynamics in the new series and take a view on possible slack in the economy.

However, the re-based CPI data will be a more important input to judge whether the disinflationary process is on track or not. One hopes that the new series does not spring a surprise like the GDP data. It is anyway expected that inflation will inch up a bit in the March quarter, but we do not think that the increase will be large enough to be a cause for concern. Oil prices have also increased in the last few days and any developments on that front will be closely watched.

On top of the inflation data, the budget is going to hold the key to future easing. Clearly, RBI will not be comfortable running an accommodative monetary policy simultaneously with a loose fiscal policy. The focus will not only be on the government meeting the fiscal deficit target for 2015-16, but also on the quality of fiscal consolidation. If the government decides to push the pedal on public investment by temporarily pausing on fiscal consolidation, then RBI would be more cautious about future rate cuts.

If the re-based CPI data follows the current trend and the government adheres to fiscal consolidation, then a post-budget inter-meeting rate cut cannot be ruled out. However, RBI is looking at keeping the real policy rate within a 150-200 basis points range. So, even with inflation moderating in 2015-16, further rate cuts could be limited to 50 basis points. One basis point is 0.01%. Oil prices need to stay low for long and more structural changes need to happen in the food economy to have inflation stabilizing at closer to 5% and opening up the space for more sustained monetary easing.

Interestingly, relatively elevated interest rates have posed the issue of overvalued exchange rates as well. RBI has played down the REER (real effective exchange rate)-based overvaluation of the currency by stressing on the need to correct for productivity differentials. However, in a global environment of ample liquidity, low interest rates everywhere and policy induced currency weakness, the promising India story and high carry gains are likely to draw in substantial capital inflows. So, persistent intervention would be required to ensure that relative overvaluation of the currency does not act as another hurdle for economic growth in 2015. In an interesting departure from the recent past, the February monetary policy has stressed on liberalizing more capital outflows and improving the quality of capital inflows. This is intended to ease the appreciation pressure on the currency and be better prepared for an eventual tightening by the US Federal Reserve.

Samiran Chakraborty is MD and head, South Asia Macro Research, Standard Chartered.

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