The monetary policy committee in its last meeting for the financial year voted to keep the repo rate unchanged at 6% and maintain a neutral stance. The accompanying statement struck a balanced tone, pointing out that while the risks to inflation are on the upside and hence vigilance is required, a nascent recovery is in the offing and that needs to be supported too. The decision was, however, not unanimous as one member voted for a 25 basis points rate hike. The underlying growth and inflation forecasts and the uncertainties around the inflation outlook seem to have prompted the majority of the MPC to seek more clarity through income data and other developments.
The guidance on the future path of inflation is cautious. Headline CPI inflation is expected to rise from an average of 4.6% in Q3 to 5.1% in Q4 and range between 5.1% and 5.6% in the first half of FY19, before easing to 4.5-4.6% in the second half. The balance of risks to this trajectory are on the upside and emanate from higher oil prices, rising non-oil inputs costs being passed to output prices and elevated household inflation expectations. Overall inflation outlook is subject to significant uncertainty from the staggered impact of implementation of HRA hikes by states, fiscal slippage, and changing expectations about the pace of global monetary policy normalization. The statement also notes that the new guidelines for fixing MSPs for the kharif crop in 2018 is an area of uncertainty and any impact assessment on inflation is difficult at this stage.
Interestingly, easing inflation in the second half of the next fiscal year assumes softer food inflation, and that may actually turn out to be the key source of upward drift from the RBI’s trajectory. It is reasonable to assume that the under the new formula and ahead of the national elections next year, average MSP increases may turn out to be larger than what the government has provided in the last four years. That, in turn, would stoke food inflation even with a normal monsoon and lead to higher-than-anticipated inflation. It thus appears that while the balance of risks is seen on the upside, the overall approach on the future guidance on inflation is less conservative than in the past.
Balancing its concerns on inflation, MPC also acknowledged that economic recovery is in a nascent stage and needs to be supported. RBI projects real GVA growth to pick up to 7.2% in FY19, up from 6.6% growth forecast in the current fiscal and the risks to this growth path are evenly balanced.
RBI continues to project higher growth in FY18 versus the CSO’s advance estimate of 6.1%. Signs of revival in investment activity and stabilization of GST implementation, are seen driving growth higher over this year and the next. This appears to be a reasonable estimate of growth, considering the recent improvement in manufacturing sector activity and a synchronized pick-up in global economic activity. However, weak private services sector activity (as seen from PMI services reading hovering close to the 50 mark) and the drag from net external demand are something which could impart some downside to this forecast.
Going forward, the path of monetary policy would be dependent on how the actual inflation and GDP growth evolve. If the headline CPI inflation follows the guidance path, then a prolonged pause on policy rates will remain as the base case. However, the upside risks to inflation (especially from food inflation and rising commodity prices) may outweigh the downside from low capacity utilization and possible correction in oil prices. The likelihood of actual inflation drifting towards the upper level of the inflation tolerance band (6%) has therefore increased. That may call for not only vigilance on inflation but a pre-emptive rate hike in July or August without changing the neutral stance. For the policy stance to change to hawkish, not only do some of the inflation risks have to gain strength, but even the growth out-turn has to be better than the RBI projections, thereby stoking demand-push inflation.
Gaurav Kapur is the chief economist of IndusInd Bank Ltd. Views are personal.