RBI to remain on the sidelines
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We expect the Reserve Bank of India (RBI) to stay on hold next week, but the tone of the statement is likely to turn less hawkish, given recent favourable developments on the inflation front.
In April, the monetary policy committee (MPC) members had highlighted potential upside risks to inflation from a variety of factors. The concerns related to some of these risks—sub-normal monsoon, imported inflation, exchange rate pass-through, goods and services tax—have reduced with a normal monsoon forecast, subdued global oil prices, rupee’s 6% appreciation year-to-date, and broadly non-inflationary tax rates related to GST. Growth also continues to be sub-normal at this stage.
Meanwhile, near-term inflation developments have surprised favourably. The April inflation print (3%) should comfort RBI, as it also reflects moderation in core consumer price index (CPI) inflation momentum. The good news is that CPI will likely fall further in May and June, closer to the 2% mark, which will lead to an average inflation of 2.5% for April-June. As the favourable base starts wearing off, CPI should start moving up, but only modestly; our estimates suggest CPI averaging around 3.5% in July-September. Consequently, CPI is likely to average around 3% in the first half of FY18, which will be almost 1.5% lower than the RBI’s baseline estimate.
In the second half of FY18, we forecast CPI to average slightly lower than 5%, which should result in 4% average inflation for the full fiscal year. This will constitute 2.25% real interest rate on an average, assuming repo rate is maintained at 6.25%. So this begs the question: should RBI consider shifting its stance to an easier bias and cut the repo rate to bring real rates down to 1.75% on an average?
As far as the strategy on real rates is concerned, the question that needs to be answered is whether there has been an adequate structural shift in the economy, which will help sustain CPI inflation at 4% levels on a durable basis from hereon. We think that’s a difficult call to make at this juncture, even while acknowledging that a number of supply side and administrative measures have helped to improve particularly food and overall inflation dynamic materially in the last few years.
As per our own baseline estimate, CPI inflation rises to 4.5% (average) in FY19, from a likely 4% in FY18. So, in case RBI decided to cut rates by 50 bps this year, it could possibly lead to rate hikes next year, if inflation were to rise to 4.5% or slightly higher in FY19, as per our forecast.
Or in other words, the central bank, in our view, should only consider going for deeper rate cuts, if data were to suggest persistently that India has managed to achieve its goal of containing CPI inflation at 4% on a durable basis. This should also reflect in household inflation expectations easing consistently from current levels.
As far as growth is concerned, we think the recent January-March data is exaggerating the extent of weakness, particularly when measured in real terms.
We note that nominal GDP growth improved to 12.5% in January-March (up from 10.4% in the previous quarter), but real GDP growth was pulled down due to i) higher GDP deflator; ii) an unfavourable base and iii) possibly some spillover from demonetization.
With GDP deflator expected to be lower in April-June, real GDP growth should return to the 7-7.5% range, even if the last quarter’s nominal GDP growth rate is maintained. Moreover, it should be noted that the slowdown on the investment front is despite RBI having cut rates by 175 basis points in this cycle. Of course, one could argue that this means RBI should be cutting rates even more, but it is quite evident by now that monetary easing is not the panacea for private investment recovery; on the contrary, it could fuel stronger consumption growth, which could lead to higher inflation expectations in the future.
Then there are global factors. There is a non-trivial risk of the US Fed to start reducing the size of its balance sheet, probably starting from the fourth quarter of 2017, which could potentially lead to capital outflows from emerging markets including India. RBI will have to keep this risk in mind, while deciding on the future course of monetary policy action.
In our view, preserving some buffer, in terms of slightly higher-than-warranted real rates (on an annual average basis), will provide flexibility to RBI to defer any potential risk of rate hikes, if they were to arise sometime later next year. In this context, we would prefer the central bank to remain on an extended pause at the current juncture, and wait for more evidence to ascertain how much of the current disinflation is owing to transitory and durable factors.
In our view, this is an opportune time to keep the rate discussion on the sidelines and focus more on pressing issues such as bad loan resolution in public sector banks and managing the surplus liquidity in the banking system.
Kaushik Das is the India chief economist at Deutsche Bank AG.