MPC policy review on October 3-4: RBI likely to hit pause button over high consumer inflation

Written by George Mathew
| Mumbai |
Updated: October 2, 2017 12:41 am


Reserve Bank of India.

While the weak GDP growth in the June quarter triggering a demand for a fiscal stimulus, the prospects of a cut in interest rate by the Reserve Bank of India (RBI) had been dampened by the high consumer inflation print of 3.4 per cent in August, according to analysts and research firms.

The six member Monetary Policy Committee (MPC) of the RBI which will meet on October 3 and 4 is likely to keep the benchmark Repo rate — the RBI’s lending rate — at 6 per cent. “The RBI is likely to hold policy rate given upward risks to inflation due to expectations of lower farm output, likely rise in global crude oil prices, depreciating currency, implementation of 7th pay commission award, expectations of US Fed rate hike and impact of GST implementation on overall pricing structure,” said Dr Arun Singh, lead economist, Dun & Bradstreet India.

That is likely to be the scenario unless RBI Governor Urjit Patel does what one of his predecessors, Bimal Jalan did well over a decade ago. In fact, in August 2003, the then RBI Governor Jalan had cut the policy rate to 4.5 per cent, 50 bps below the then 5 per cent WPI inflation target. This successfully supported recovery rather than stoking inflation. How much more can the RBI cut? “We think that the RBI MPC can at least cut rates another 25 basis points before hitting a long pause. First, the long global recession justifies negative real rates of 50-75 bps in our view. Assuming 6.5 per cent long-term CPI inflation as a proxy for inflation expectations, today’s 6 per cent RBI repo rate yields a negative ex ante real rate of 50 bps,” Indranil Sen Gupta, India chief economist of Bank of America Merrill Lynch said in a report.

The RBI’s first 50 bps cut in the March 2015 quarter went waste as the busy industrial season impeded transmission to bank lending rate cuts. Finally, the rate differential with the US Fed remains about a comfortable 450 bps even with a December Fed hike and a final 25 bps RBI rate cut, he said.

Research agencies said rising inflation is the big risk. “Indeed, with inflation expected to rise closer toward the RBI’s inflation target, we do not think there is much room to ease monetary policy further. Moreover, the potential fiscal easing would have to be evaluated in the context of its impact on inflation,” Morgan Stanley said in a research report. “Inflation pick-up was more broad-based than in recent months, with higher food accompanied by an increase in housing and service categories,” said Radhika Rao, economist, DBS Bank.

Expectations of lower output in rice, maize, soybean, groundnut, tur and moong along with rising global crude oil prices are expected to keep inflation elevated. “On the monetary side, previous rate cuts in the policy rate are yet to be reflected in the lending rates proportionately. Further, inflation risks have gone up since third bi-monthly monetary policy review meeting held in August,” Singh said.

Overall, the current economic scenario may not be encouraging. The index of industrial production grew at a dismal 1.2 per cent in July 2017, bank credit is showing no signs of a pick-up, consumer price index based inflation at 3.6 per cent in August 2017 is a five-month high and current account deficit at 2.4 per cent of GDP in June quarter is a four-year high. “Also with inflation inching up, despite the clamour for further monetary easing, the RBI will have less elbow room to reduce policy rate further. Moreover, a further reduction in policy rate is unlikely to make much of a difference, particularly on the investment front, given the large idle capacities in several manufacturing sectors,” India Ratings said.

According to Care Ratings, major factors that could lead the RBI to maintain status quo on policy rates in the October monetary policy meet include fall in crop sowing area by 7.7 lakh hectares this year compared with year ago levels resulting in lower farm production, changes in tax rates on account of GST, inflation in housing index with implementation of 7th Pay Commission and increase in prices of imports on account of recent rupee depreciation and increasing crude oil prices. If the US Federal Reserve hikes interest rates, foreign portfolio investment will come down further. The month of September witnessed FPI inflows on expectations of rate hike in the US. A further increase in outflows could impact the current account deficit.

The RBI policy review comes at a time when demonetisation and GST have disrupted economic activity. Although the rollout of GST was fairly smooth and the first month revenue collections were encouraging, some stress points have emerged. Destocking by manufactures and the loss of liquidity for exporters due to delayed GST refund has impacted business activity. Investments too have failed to pick up with small business units being affected the most.

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