Fiscal and economic policies will determine quantum of RBI rate cuts

The Reserve Bank of India (RBI) is widely expected to pause at the fifth bi-monthly policy review. The central question now is the depth and timing of further cuts possible over the next few months.

RBI at end-September guided that the “front loaded” 50 basis point (bps) repo rate cut “ensures expected real 1-year T-bill rates of 1.5 – 2%, which are appropriate for this stage of the recovery”. These yields are usually about 25 bps above the repo rate, so the appropriate real repo rate range would be 1.25–1.75%. With our current forecast of average Consumer Price Index (CPI) inflation in 2016-17 around 5.1%, an appropriate repo rate range would be 6.25–6.75%, centred at 6.5%.

Despite the continuing slump in global commodities prices, which are not expected to recover in the medium term, and the anaemic economic recovery during most of remaining FY16, there are risks to the inflation outlook, both direct and indirect, which will shape the monetary policy stance. Till there is greater clarity on these issues, it is unlikely that further easing will happen in the near future.

First, the Fed Funds Futures market is currently pricing a 74% probability of a rate hike at the 16 December federal open market committee meet, based on economic data as well as statements from Fed voting and non-voting members. There is bound to be near-term re-deployment of capital towards developed markets, with resultant global volatility and thereafter persist with weak data from China and other emerging markets. Part of India’s portfolio capital holdings still remain as part of global indices and will be vulnerable to emerging market selloff. The resultant volatility in and depreciation pressures on the rupee will adversely impact both corporate balance sheets and imported prices.

Second, India’s fiscal trajectory will weigh on RBI’s assessment of risks to domestic consumption demand. It is early days yet to assess the fiscal impacts of the Seventh Pay Commission, and the implementation will become clear only after the FY17 Budget. Although we do not expect the net impact to be materially more disruptive than we now estimate, there is the possibility that the pay hikes, in combination to expanding one-rank-one-pension coverage might disrupt the fiscal consolidation path. In addition, if a transition to goods and services tax does indeed happen, the initial impact is likely to be inflationary, before efficiency gains reduce overall costs.

Third, rising food prices have again come to the fore. After a second consecutive year of disrupted rainfall, predictions of strong persisting El Nino conditions have increased the risk of global food inflation for 2015, persisting into 2016. For the last 18 months, despite widespread perceptions of weak rural demand, rural CPI inflation differentials over urban geographies have shot up. Whatever the cause, in the event of future crop failures and supply disruptions, these will become magnified. Initial rabi season crop sowing patterns and rainfall conditions are already discouraging.

CPI inflation is likely to print around 5.5% in January 2016, a shade lower than the 5.8% indicated by RBI. Average inflation in FY16 is likely to be around 5.1% and slightly higher in FY17. While this track will take inflation close to RBI’s 5% target at end-FY17, managing the disinflation dynamics for the transition to the next milestone of 4% in January 2018 will be tricky. Global disinflationary trends are likely to have dissipated and Indian growth recovery well underway, with consequent producer pricing strength.

Current estimates of capacity utilization indicate that pricing power will at best remain moderate. How the gap between demand and existing capacity plays out in the near term is likely to influence the magnitude of cuts. With signs of growth revival only incipient, and credit conditions still weak, it is likely that RBI’s “stance will (still) continue to be accommodative”. Banks have transmitted 65-70 bps of the 125 bps repo cut by RBI, lending rate, including retail loans, cut in varying degrees. Demand for housing, auto and consumer durables loans will eventually accelerate, as spending in these and other consumer goods sectors increases. However, a sustained increase in industrial demand will probably need some more time.

In the meantime, policy reforms and implementation, project de-bottlenecking and process improvements will take centre stage. These will allow room for further monetary policy easing, but a further 25-50 bps cut in the repo rate is unlikely before the Annual Policy review in April 2016.

Saugata Bhattacharya is senior vice-president, business and economic research, Axis Bank. Views are personal.

Source : Livemint