RBI stance on inflation and growth expectations more dovish now
By ABHEEK BARUA, CHIEF ECONOMIST, HDFC BANK
As we had expected, the Reserve Bank of India (RBI) in its fourth bi-monthly monetary policy review reduced the policy repo rate by 25 bps from 6.50 per cent to 6.25 per cent. Consequently, the reverse repo rate was adjusted with a similar magnitude to 5.75 per cent and the marginal standing facility (MSF) rate to 6.75 per cent. In its statement, the central bank highlighted that food inflation outlook could improve further in the coming months on account of ‘strong improvement’ in the sowing along with supply management measures of the government (especially with regard to pulses). In terms of risks, the committee highlighted the potential impact of seventh pay commission awards (HRA especially) and increase in minimum wages. The statement stated that while these factors require continued vigilance, on balance, the 5% goalpost for March 2017 seems achievable. In terms of economic growth, RBI retained its 7.6 per cent GVA forecast for FY17. The central bank stated that even as growth is expected to quicken on account of a normal monsoon, rise in agricultural growth and rural demand, as well as by the stimulus to the urban consumption spending from the Pay Commission’s award, the sluggishness in world trade could offset some of the gains. On investments, RBI recognised the recent slack but said that business expectations polled in industrial outlook survey are suggestive of expansion in Q2 and Q3. On the liquidity front, RBI highlighted that conditions have remained comfortable and as a result of continued OMOs, the weighted average call money rate (WACR) has remained tightly aligned with the policy repo rate, and that interest rates on commercial paper (CPs) and certificates of deposit (CD) have also eased. In our view, RBI’s stance on inflation and growth expectations appears to be more dovish than initially envisaged: >> Downplaying the risks related to HRA hike under the seventh pay commission awards, Governor said that there are “both upside and downside risks to inflation”. As the governor himself pointed out in his interaction with the press, the RBI could look through the initial and direct impact of HRA hike going forward. This gives us comfort that RBI in the future could ignore one-off cost pushes or supply shocks unless there is a significant risk of the shock getting generalised and percolating through the system. >> With regards to the comfortable level of real interest rates, another MPC member said that there is room to go below the current level (1.5 per cent) by 20-30 bps. This too signals a change in stance and is different from the range of 1.5 per cent to 2 per cent propagated by RBI until now. While there is some risk to financial savings from a lower target real interest rate, there is clearly a trade-off involved. Past data has shown that financial savings have remained robust even at real lower rates of interest and some reduction in the real rate given sluggish growth conditions is warranted. >> Before the meeting, the markets had slotted the MPC members into neat ‘dove’and ‘hawk’ categories. The unanimity in votes for the rate cut decision suggests two things. First, this binary classification is somewhat misleading when it comes to gauging policy action and instead of being constrained by dogma, the MPC members can take a comprehensive data-dependent approach to the problem at hand. Secondly, it also reveals the central bank’s need to support growth is important at this stage given the large output gap and soft inflation. Bottom Line A unanimous vote for rate cut and acting in accordance with the inflation data suggests that one more 25bps rate cut could be in the offing by year end. We expect retail inflation to dip below 4.5 per cent level by December. While part of this decline is likely to be on account of food inflation, favourable base effect would also be supportive of the overall trajectory. If the decline in food inflation is more than expected and if the global markets remain stable around the US Fed’s decision in December, another 25bps cut in the repo rate could come as early as the next monetary policy review of RBI.