RBI may hike repo rates next week to preserve macro stability
We expect RBI to hike the policy rate by 25bps on 1 August, but pause thereafter as CPI inflation starts moderating
We expect the Reserve Bank of India (RBI) to hike the policy repo rate by 25 basis points (bps) on 1 August. We also see RBI changing its neutral stance to hawkish, though there is a possibility that the central bank may prefer to keep the stance unchanged, given the volatility in crude oil and food prices.
While food—and consequently, headline—Consumer Price Index-based inflation surprised to the downside in June, core CPI inflation (CPI excluding food and fuel) firmed up to touch 6.4%, versus 6.2% in May. The downside surprise to the June headline CPI inflation print may provide some comfort, but core CPI inflation trend should continue to worry RBI, in an environment where output gap is narrowing, global oil prices remain elevated, forex pass-through risks to inflation are on the rise and a double-digit increase in minimum support prices (MSPs) raises risk of stoking second-order inflationary impact, albeit with a lag.
True, CPI has surprised to the downside in June, but it is still at 5% and, more importantly, core inflation is close to 6.5%, while 12-months ahead inflation is also likely to be around 5%. A forward-looking inflation-targeting central bank like RBI will likely act pre-emptively, particularly when the currency also remains under pressure and persistent Fed rate hikes carry the risk of more debt outflows, if interest differentials are not sustained adequately. Global oil prices have corrected, but are still hovering above $70 per barrel, which is high enough to push current account deficit toward 2.5% of gross domestic product (GDP) and lead to a sizable balance of payments deficit in FY19. RBI, in our view, will continue to be worried about the oil price trend, unless and until there are clear signs of Brent breaking sustainably below the $70 mark.
Assuming the monsoon will be normal, and the impact of an MSP increase will be limited between 25 bps and 50 bps, depending on the procurement dynamic, CPI inflation will moderate to about 4% by December 2018, to rise thereafter to 4.7-4.9% by end-March 2019. In this scenario, CPI inflation is likely to average around 4.75% in FY19, which should imply a terminal repo rate of 6.75%, assuming RBI wants to target 2% real rates over the medium-term to maintain macro stability.
The current WPI inflation trend is also worrying, particularly related to sharp increase in non-food manufactured goods inflation, which is considered a proxy for WPI core inflation. RBI has made it clear that its comfort range with core WPI inflation (non-food manufactured goods inflation) is around 4%. Therefore, with core WPI inflation already at 4.8% in June and likely to rise further, RBI will probably be cautious about the evolving inflation momentum in the manufacturing sector and, hence, monitor this inflation measure closely.
The common theme that emerges from looking closely at the different components of WPI and CPI inflation is that core inflation remains the main driver of headline inflation at this juncture. This uptrend is also corroborated by the composite PMI input and output price movement. The rise in core inflation is coinciding with ongoing cyclical upswing in growth, which is not completely unexpected. While RBI remains committed to keeping headline CPI inflation around 4% on a durable basis, it wants to achieve this primarily by keeping core inflation closer to 4%, so that inflation expectations of households can drift lower on a sustained basis.
We estimate CPI core inflation to be about 100bps higher in FY19 compared to the FY18 outturn, and core WPI inflation to be higher by about 150bps. Irrespective of the volatility in food price inflation, this inflation “signal” should warrant further monetary tightening by RBI, to anchor inflationary expectations.
With India’s investment cycle poised for a cyclical upswing from FY19, after years of sub-par performance, it is important that the policy stance is geared toward incentivizing a rise in domestic savings to fund incremental investment needs. RBI needs to tighten monetary policy to ensure that real rates remain positive closer to 2%. This is required to temper inflation expectations of households (close to 10% currently for one-year-ahead period) and incentivize greater mobilization of financial savings in the economy. If this is not achieved, then either the pressure on current account deficit will increase, to fund the shortfall in domestic savings-investment balance, or investment growth needs to slow down to keep the current account deficit under check, both being sub-optimal outcomes.
A closer look at India’s external trade profile including current account deficit reveals that India remains vulnerable to higher oil prices, in the absence of any quick-fix solution to reduce non-oil trade deficit in a meaningful manner. In this backdrop, India will need to depend primarily on both monetary and fiscal tightening to preserve macro stability, in our view.
Given these risks, we expect RBI to hike the policy rate by 25bps on 1 August, but pause thereafter as CPI inflation starts moderating in the second half of 2018. Beyond August, we see RBI hiking next in April, once inflation starts inching toward 5% in the January-March 2019 period.
Kaushik Das is India chief economist Deutsche Bank.
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