We think that space might now have opened up for a repo rate cut at the next monetary policy review meeting. Market interest rates have also largely priced in a cut. However, this will be a difficult decision for the Monetary Policy Committee (MPC), from the perspective of guiding the forward path of inflation, which will be the focus of the deliberations. The causes of the unanticipated drop over the past three months will have to be evaluated and form the basis of the trajectory over the next year and in the medium term. A critical analysis of the factors driving inflation will be key.

Consumer Price Index, or CPI, inflation has slowed from 6.1% in July 2016 to 1.54% in June 2017, and is projected to remain sub-2% till August 2017 before climbing to 3.6% by March 2018. Assuming that much of these changes are due to base effects, how much can the MPC “look through" the expected near term? This is where it becomes relevant to look at the degree of unanticipated deviation of actual and predicted inflation and the proximate causes for the deviation.

The 4.5-percentage point drop in inflation was mostly attributable to the food basket (with a drop in the corresponding inflation from 8.0% to -1.2%, and within that, to pulses and vegetables). Is the deflation story mostly done in this category?

There are still multiple risks. The trajectory we mentioned earlier over the next one year was the base case. Other than relatively unquantifiable impacts of a renewed tightening of capacity in China, the effect of the rollout (and capture of the phenomenon in price surveys) is likely to add another 0.8 percentage points to the base trajectory over the year, taking the March 2018 inflation rate to 4.4%, and rising thereafter to 5.6% by June 2018 and softening thereafter to 4.3% by March 2019. Of course, these are indicative trajectories, but the broad shapes will resemble our base forecasts. In addition, rural wages have been rising steadily, although the cause is not particularly clear, and consequently its sustainability is uncertain. On top is the effect of the goods and services tax, or GST, implementation, which we think might marginally lower CPI inflation in the near term.

Globally, after concerns (or hope in the developed markets) that the deflationary episode was dissipating by mid-2016, with inflation beginning to pick up towards the mandated targets, there is now emerging a view that global growth might actually slow, and consequently the pickup in inflation begin to moderate. The consequent concern about the negative impact on portfolio capital inflows from the widening differentials in interest rates is likely to moderate.

In this environment, the MPC will have to consider the prospects of the trajectory falling even further than expected. This has happened in the past, particularly on food inflation. And this has been a gap not just in the Reserve Bank of India’s (RBI’s) inflation projections, but also of the median of the responses of the Survey of Professional Forecasters (SPF), who had, if anything, thought that the pickup in inflation would be even steeper than RBI’s projection. So, will the MPC be correct in “looking through" the near-term dip in inflation, the subsequent pickup and stabilization a year hence of the inflation track close to the medium-term target of 4%?

Another important factor in a rate-cut decision will be the objectives achieved by lowering interest rates. How much is this likely to help in reducing the output gap? The real interest rate (the difference between the one year ahead T-bill rate) is currently much higher than the 1.25-1.75% targeted by RBI as the “neutral rate". Growth prospects will pick up, as will consumption demand post a normal monsoon and increase in investment activity, but RBI’s own capacity utilization surveys indicate that pricing power will at best remain moderate.

One important determinant of the MPC decision will be changes in inflation expectations of households. Although tracking the downward move in CPI inflation, these have remained fairly sticky and significantly above the actual inflation rate (particularly the one-year-ahead expectation) at the time of the May 2017 survey. The results of the RBI Survey launched in June will likely show a drop in expectations, particularly the near term, as a response to the drop in salient commodities observed by households. If the MPC were to “look through" the current oscillations in inflation, confidence in easing policy would have to depend on a reading of more structural factors over the longer term. One of these factors—increases in the minimum support prices of agricultural commodities—has been extensively analysed and the risk of immoderate rises seem to be low. The other important factor will be the view on a shift in household savings from physical to financial sector instruments, early signs of which are already evident in the accretions in mutual funds.

Saugata Bhattacharya is chief economist at Axis Bank.

This is the first of three columns in the run up to RBI’s third bi-monthly monetary policy statement for 2017-18 on 2 August.