Slower GDP growth may lead to a dovish tilt by RBI’s monetary policy committee
A key piece of information available to the monetary policy committee (MPC) —GDP growth slowing down in Q1 to its lowest in 13 quarters—will have a significant bearing on the deliberations at its meeting next week. While the headline consumer price index (CPI) inflation has gone since the last meeting from 1.46% to 3.36% and core inflation has quickened to 4.6% in August, this was along expected lines, especially as the supportive statistical base effect faded. The slowdown in growth witnessed in Q1 would, however, require a reassessment of the real gross value added (GVA) growth forecast for FY18. The Reserve Bank of India (RBI) has maintained that at 7.3%. With the economy underperforming in Q1 and with a drag on activity from goods and services tax (GST) implementation having continued in Q2, that forecast would be revised downwards. That in turn will have a bearing on forward guidance on inflation too.
The decision to cut or hold rates, among other things, will be dependent on the view the MPC takes on the nature of the slowdown. If the slowdown is seen as transitional and hence reversible shortly, then it has to be seen through. If on the other hand, it is seen as evidence of a prolonged slowdown which began last year before demonetization, then there is a case for using the monetary space available. Space for another 25 basis points (bps) cut exists, if we were to consider that a neutral level of real policy rates is within a range of 1.25-1.75% and that the headline inflation over the next one year is likely to average around 4.3-4.5% (including the statistical impact of an HRA hike). With gross value added (GVA) growth likely to be lower than 7% for a second successive year and with private consumption growth slowing, the upside risk to inflation from the economy reverting back to its potential level has receded.
The balance of other risks may, however, have shifted upwards to some extent. Normalization of perishable food item prices post remonetization has pushed up food inflation and that may persist for a couple more months. A shortfall in monsoon rain coupled with its uneven spatial distribution has affected kharif sowing and foodgrain output is projected to be lower by 3.86 million tonnes compared to the previous year. Commodity prices have hardened in recent months on a synchronized global economic recovery led by China, which is visible in core wholesale price index (WPI) inflation picking up on imported inflation. Oil prices have risen and remain supported due to an Opec (Organization of the Petroleum Exporting Countries) production cut. And, the rupee is now trading with a weakening bias on the back of volatile capital flows, rising geopolitical tensions and widening current account deficit (CAD). Sticky core CPI inflation is also witnessing upward pressure due to a higher tax rate on services in GST. All these risks remain contained though.
A notable development since the August meeting is that monetary policy normalization by major global central banks is gaining momentum. The US Fed will start reducing its $4.5 trillion balance sheet from October, thereby tightening dollar liquidity gradually. The Fed’s rate-setting committee has also reiterated its guidance for one more hike in December followed by three rate hikes in 2018. The European Central Bank’s governing council is expected to announce a reduction in its €60 billion bond-buying programme from 2018 in its October meeting. The Bank of England has hinted at raising rates too. While market reaction has so far been benign, asset prices remain prone to a sharp correction, which can adversely impact the rupee and capital flows to India.
A noteworthy domestic development relates to government considering a fiscal stimulus, even as public spending has been a key driver of growth. Any measures which could put stress on already stretched central government finances are bound to be viewed as inflationary. Some members have already raised concern on state finances from farm loan waivers and their adverse impact on inflation. Any fiscal stimulus via consumption combined with monetary accommodation already provided could push inflation higher, especially as investment activity remains weak. That can also increase risks to macroeconomic stability along with an already widening CAD driven by consumption.
Thus, while awaiting further evidence on the nature of growth slowdown, ongoing implementation of GST and considering that CPI inflation now is moving up and will soon cross the 4% mark, the MPC is likely to maintain status quo on rates. However, acknowledging slower growth will mean a dovish tilt in the guidance. Improving monetary transmission will remain a focus area in the meantime.
Gaurav Kapur is the chief economist of IndusInd Bank Ltd. Views expressed herein are personal.
This is the second in a series or columns ahead of RBI’s bi-monthly monetary policy meeting on 3 and 4 October.