India’s monetary policy outlook: What’s not to like?

September 29, 2016
A money lender counts Indian rupee currency notes at his shop in Ahmedabad, India, May 6, 2015. REUTERS/Amit Dave/File Photo - RTX2GH3F

A money lender counts Indian rupee notes at his shop in Ahmedabad, May 6, 2015. REUTERS/Amit Dave/File Photo

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Through the scorching heatwave and soaring food prices over the summer, we remained hopeful that inflation will fall. We’ve been saying for a while that reservoir levels were an important determinant of food prices. And given that early rains filled up India’s reservoirs to near-normal levels by August, we were not surprised to see the subsequent sharp fall in food (from 8 percent year-on-year in July to 5.8 percent in August) and overall (from 6.1 percent in July to 5 percent in August) inflation.

And it does not end there. As more of the new crop trickles into the market over the next few months, inflation could fall further. Vegetable prices could completely reverse their summer ascent of 110 bps. Furthermore, higher pulse production on the back of a rapid increase in sowing could reduce inflation by another 40 bps.

All things considered, CPI inflation could fall to under 4.5 percent in the January-March 2017 period. Moreover, inflation is likely to remain below the RBI’s early 2017 target of 5 percent for the next 12 months, opening up space for monetary easing.

With luck, core inflation could also soften
Falling food prices, through the expectations channel, could gently soften stubbornly high core prices. Previously, we found that the strength of growth (i.e. the output gap), while still significant, is not as important in determining inflation as before (i.e. the Phillips curve has flattened). On the other hand, the role of food prices in determining core prices has risen meaningfully. If seasonal food prices drop now, and are kept low due to structural reforms such as e-markets in agriculture and reforms in food distribution, it could also help soften core prices over time.

Some may rightfully ask that if softening food prices matter so much, why didn’t core inflation fall over the last year when food inflation was moderating? And here, we have a nuanced answer. Inflation expectations are impacted by various factors, one of them being the dominant impact of a few crops that remain inflationary despite prices of all others falling. Recall that pulse inflation remained high through the last year (35 percent year-on-year) and this probably prevented inflation expectations falling by too much.

What rate cuts can we expect in the foreseeable future?
The RBI has two objectives – to reach its 5 percent inflation target in early 2017 and keep real rates at the 1.5-2 percent range. Achieving both would open up space for easing by 50 bps. We expect a 25 bps rate cut at both the December and February policy meetings.

A rate cut in October is a close call …
More certain is the continuation of the RBI’s accommodative stance and liquidity infusion. There are still some good reasons why the rate cut could materialise in October. The recent fall in food prices has been sharper than expected, and cutting earlier keeps the RBI a safe distance away from possible Fed hikes. Yet, our base case is for a rate cut in December rather than October. This is because, by December, two new inflation prints which are expected to be well below 5 percent will be available.

Moreover, given that the RBI was highlighting upside risks until its last meeting, it may prefer to move in steps, i.e. change the outlook on inflation now and cut rates in December. Furthermore, to get more bang-for-the-buck for monetary transmission, the RBI may want to get through the period of foreign currency non-resident (FCNR) deposit outflows before it cuts more.

We expect the commentary on the October meeting to be dovish, with the RBI highlighting downside risks to its inflation forecasts (if not actually lowering the forecast). Either approach is likely to be accompanied by a recommitment to its accommodative stance, with the central bank stating once again that it remains data dependent. Furthermore, we also expect it to continue to infuse liquidity into the banking system by buying dollars and government bonds. Our estimates point to a BoP surplus of $25 billion in FY17, and given the possibility of currency leakage to the tune of 2.5 trillion rupees ($37.3 billion) this year (even more than last year’s elevated 2.1 trillion), we expect bond purchases to continue at a rapid clip if the RBI wants to move closer to its aim of closing the rupee deficit.

The decision-making process
It is likely that the policy decision on October 4 will follow an intense discussion between the six members of the new monetary policy committee (MPC) comprising three economists, two senior RBI officials and RBI Governor Urjit Patel. Our study of the situation suggests the outcome will be the same regardless of whether the decision is made by the governor alone (as has been the practice before), or by the MPC. Given institutional tradition and the fact that RBI staff use a common pool of data and analysis, we believe the three RBI members of the MPC will vote as a bloc. And in case there is a tie, the RBI has the casting vote.

What next?
The horizon beyond our projected 50 bps cut in rates is hazy. There are some policy-related upside risks to inflation in the second half of 2017, such as the second round effects of the government wage hikes and a temporary spike in inflation if GST rates are over 18 percent. Some could be overlooked by the RBI given that they would be a one-time jump in inflation. But only when the scale of the increase is known, which will take time, would the RBI be able determine how much of the impact can be safely overlooked.

In light of these risks and the RBI’s desire to eventually move towards the mid-point of the 4 percent +/-2 percent band, we expect the 50 bps rate cuts to be the last in the cycle.

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