The logo of Reserve Bank of India (RBI).
The logo of Reserve Bank of India (RBI).

Opinion | There’s room for a rate cut in August, followed by a  pause

The core-CPI inflation may not see a meaningful easing in the coming months

After the cumulative 75 basis points (bps) of easing effected in the previous three reviews, the Monetary Policy Committee (MPC) appears likely to cut the repo rate by a further 25 bps to 5.5% in August, a level last seen in 2010.

Although an uptick in food inflation has led the consumer price index (CPI) inflation to rise to 3.2% in June 2019, it remains below the MPC’s medium-term target of 4%. This supports the case for an imminent rate cut, particularly given the weak performance of various domestic economic indicators. However, the Indian inflation outlook is less sanguine, which suggests that a cut in August may be followed by a pause.

The unsatisfactory distribution of the monsoon rainfall has delayed kharif sowing, which may negatively impact yields and food prices.

Additionally, rising vegetable prices and an unfavourable base effect would result in food inflation continuing to increase in the coming months, in Icra’s view. Moreover, the hike in duties and cesses on fuels introduced in the Union budget for FY20 is likely to have a modest first and second round effect on retail inflation.

Despite the subdued economic growth outlook, the core-CPI inflation may not witness a meaningful easing in the coming months, as the demand for various services such as education and health is likely to remain sticky.

Additionally, the recent revision in house rent allowance by states such as Haryana is likely to push up the housing component of CPI inflation. Overall, we expect retail inflation to continue to rise in the coming months, and cross 4% sometime in second half of FY20..

Evidence from various sectors, such as auto production and fast-moving consumer goods (FMCG), suggests that urban and rural consumption demand is weak.

Indicators related to freight, such as port cargo traffic, rail freight, passengers carried by domestic airlines, as well as jet fuel and diesel consumption, all reported a weaker growth in Q1FY20 relative to Q1FY19. Moreover, the disappointing progress of the monsoon is likely to restrain rural sentiment in the near term.

Merchandise exports, which contracted in Q1FY20, are likely to report low growth in the current fiscal, given the muted outlook for global economic activity and concerns related to trade wars.

With elections, government spending also underwent a lull in the recently concluded quarter. Net of a sharp 30% rise in subsidy outgo led by fertilizers and fuel, the government of India’s revenue expenditure remained similar to the year-ago levels in Q1FY20. Moreover, capital outlay recorded a considerable 26% contraction in that quarter.

Further, Centre for Monitoring Indian Economy (CMIE) data shows a decline in new investments in the first quarter of this fiscal, which may be partly on account of postponement of investment decisions prior to the results of the Parliamentary elections.

While government spending is likely to rebound in the months after the Union budget, the high cost associated with land acquisition may dampen the pace of award of infrastructure projects. Moreover, private sector investment activity may not revive in a hurry, given high leverage levels, limited transmission of monetary easing to lending rates, moderate capacity utilization in many sectors and the availability of brownfield assets through the National Company Law Tribunal.

While further rate cuts and improved transmission of monetary easing would boost sentiment, some of the constraints to economic growth such as the moderate capacity utilization levels, cost of land acquisition, and weak outlook for farm incomes and rural consumption, may not be dissolved by lower interest rates alone. Additionally, issues related to refinancing are impacting the sustainability of some businesses.

In Icra’s view, the inflation outlook suggests that there is room for another rate cut in August. However, we may see a pause after that, as the MPC may choose to wait for additional data on the inflation-growth dynamics and deepening of policy transmission, especially if the headline CPI inflation outlook appears to be on track to drift up to 4%.

Aditi Nayar is principal economist at Icra.

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