Inflation target is a big challenge

The RBI monetary policy committee lowered the benchmark repo rate by 25 basis points to 6.25% at its first meeting on Tuesday. This unanimous vote was along our expectations.

Accompanying statements were neutral, as the panel reinforced the early-2017 inflation target of 5% but with modest upside risks. Growth and inflation projections were held unchanged. Stealth easing by way of a pro-liquidity stance is likely to continue to help markets deal with upcoming foreign currency non-resident (FCNR) maturities and ensure policy transmission remains on track. Guidance on the real rates was moderated slightly in light of the global environment of low to negative interest rates.

While we are comfortable with the inflation outlook for FY16-17, keeping CPI inflation stable around its 4% (+/- 2 percentage) band next year will be a challenge for the central bank and the government.

Here, awaiting the official word, we assume that 4% will be adopted as the CPI target for FY17-18, as and when the related RBI Acts are amended. Aggregate demand will be higher in FY17-18 due to a normal monsoon, salary increases from the Seventh Pay Commission, and steady-to-higher food prices from structural inadequacies. Implementation of the goods and services tax will also temporarily lift price pressures.

Importantly, the 4% inflation target implicitly holds the RBI responsible for the direction of food prices, the largest component in the CPI basket. As witnessed in the past three years, the RBI had little direct control over the price increases of cereals in FY11-12, vegetables in FY12-13, and pulses last year.

Food inflation is also keeping rural inflation higher than urban inflation. Since early 2016, rural inflation has been close to 6%, with urban inflation averaging 150 bps lower in the sub-5% region. Higher inflation has started to hurt demand in the rural sector with no signs of letting up and offsetting some of the anticipated gain due to normal monsoon.

Structurally, the government has been playing its part to keep inflation stable. Having met its fiscal targets for 2015-16, the government is targeting a smaller deficit this year. Taking advantage of low commodity prices, diesel subsidies were lifted. Pay commission hikes have been partially implemented, which will smoothen the impact on the fiscal books and inflation.

The minimum support prices for agricultural produce were raised modestly, down from double-digit increases in the past. Administrative measures to curb hoarding/malpractices were also taken. Investments into infrastructure are underway, particularly into roads, highways, ports, etc. More work is required on this front, especially on improving ex-farm to consumer supply chain to ensure supplies can be stepped up in case of need. It is important that this collaborative approach remains on track even when demand improves, commodity cycle turns up or the political calendar gets busier.

With the interest rate setting policy decision shifting to a policy committee, markets will seek clarity and transparency in communication to better gauge the panel’s leanings. While the FY15-16 CPI target of 5% appears within reach, achieving and maintaining inflation at 4% next year appears to be a challenge. The RBI has been tasked with setting inflation targets, but it requires the government’s collaboration to meet and maintain the 4%±(+/- 2 percentage) target band until 2021.

Radhika Rao is vice-president of DBS Bank, Singapore.