September 14 2017

Disinflationary pressures prompt RBI to cut rates in August

Summary

The latest torrent of macroeconomic data in Asia’s third largest economy has strengthened the notion of an interest rate cut from the Central Bank in the upcoming August meeting. The last two MPC (Monetary policy committee) meetings’ have not been able to provide a strong rationale for not easing in a less-adverse global environment and seemingly benign inflation trajectory. In the meantime, the MPC, however, pared their inflation forecasts down for both halves of the current fiscal year to buy some more time.

The agenda behind RBI’s neutral policy stance seems vague, and at most growth-deterrent amidst record low headline inflation figures for two consecutive months, investment slowdown and a deceleration in real GDP growth. In our view, perhaps it is time to rethink RBI’s policy stance and opt for a substantial rate cut to provide the much-needed boost in the economy.

Inflation over the decades

Historically, India has been intolerant towards high inflation. As regards, the conduct of RBI’s monetary policy has evolved over time on the front of the policy framework and operating procedure. Post-Independence period, RBI had adopted “monetary targeting with feedback” in 1985 as the policy framework to curb high inflation propelled by excessive money supply. Following the economic liberalization of 1991, RBI shifted its focus to a broad set of indicators. In more recent years (2014), it adopted the policy of “inflation targeting” and re-emphasized the primacy of price stability in an economy.

There have been several events of inflation spiraling to double digits since the mid-1990s, mostly during the UPA (United Progressive Alliance) regime. Most noteworthy, the period of 1994-95 saw a significant rise in WPI (Wholesale Price Index) figures, edging up to as high as 12.1% YoY in January 1995. The second important timeline was during 2008 when there was massive and unprecedented increase in the WPI (11.1% YoY in July '08).

Factors at work

The main drivers of inflation dynamics were: supply shocks (poor agricultural production coupled with high dependence on monsoon) which led to a rise in food articles’ price by 13.8% YoY, increase in manufactured products’ prices by 11.7% YoY; commodity price shocks (mainly oil price rise) and demand pressures of high fiscal imbalances in the mid-1980s.

The inflationary episode of mid-2008 was mainly the impact of an upsurge in international crude prices that touched a high of USD 143.3/barrel (fuel group inflation increased to 16.9% in YoY terms); hardening of food prices (primary articles’ prices surged up to 11.1% YoY) along with prices of manufactured products’ inflation going up by 10.7% YoY.

Inflation volatility has been on a declining trend

In more recent years, since RBI's shift to CPI(combined) based measure of inflation and adoption of ‘Inflation Targeting’ as the centerpiece of monetary policy framework, there has been an overall declining trend in the inflation owing to improved supply response, an accommodative monetary policy along with enhanced fiscal consolidation. In mid-2014, RBI had also proposed a glide-path for disinflation to reach 8% by January 2015 and 6% by January 2016. To everyone’s surprise, the policy stance was fulfilled well before the stipulated time by December 2014.

In June 2017, there was a significant retreat of inflation as the CPI plunged to a new historical low of 1.54% YoY; marking the third consecutive decline since March 2017. This is also the first time that the headline inflation fell below the lower bound of the targeted bandwidth (4+/-2%) since the adoption of inflation targeting regime. Consumer food price index continued to remain in the negative territory for the second consecutive month and fell to a historical low of -2.1% YoY.

Factors Entwined

Underlying this surprising decline was a sharp fall in food prices brought about by a deflation in vegetables (-21.5% YoY) and pulses (-16.5% YoY). Prices of vegetables and pulses have been on a downward trajectory since March 2017 mainly because of excess supply caused by record output levels and imports. The downward trend is likely to continue as the Indian Meteorological Department’s (IMD) forecast of a normal monsoon (June-Sept) bodes well for overall food grain production and there seems to be a low probability of an agricultural inflation in the upcoming quarter.

Crude Oil prices continued to retreat

Furthermore, the easing of international crude prices in the preceding months and a delayed adjustment in the domestic fuel prices led to a fall in the fuel group inflation for the third consecutive month to 4.5% YoY in June from 5.5% YoY in May 2017. The global crude oil price of India basket has fallen by around 15.7% since March 2017. International developments suggest that oil prices are likely to remain benign as oversupply woes remain a dominant theme at the upcoming OPEC meeting on 24th July.

Implications for RBI: Credibility at stake?

In light of recent developments, there has been a clamor for a rate cut. The growth slowdown in January-March quarter coupled with benign inflation trajectory has put more pressure on the central bank to warrant a substantial easing at the earliest. However, RBI continues to put forward an overall neutral stance and kept the repo rate unchanged at 6.25% (since October 2016) in its 2nd bi-monthly policy statement. Time and again, RBI has overestimated their inflation forecasts. For example, in October 2016, the Committee had envisaged that the headline CPI inflation would be 5% by March 2017. Following larger than expected declines in CPI in November and December 2016, RBI then lowered their projection in the range of 4-4.5% for the first half of 2017 and 4.5-5% for second half of the financial year. The forecast for June was far below expectations at 1.54% YoY which led the Monetary Policy Committee to again revise their forecast of CPI-headline inflation downward to 2 - 3.5 per cent during the first half; and 3.5 - 4.5 per cent during the second half of 2017-18.

Additionally, the May Round of 3-month and 12-month inflationary expectations survey conducted by RBI for households showed a declining trend, in tandem with the low momentum of domestic economic activity.

Even though inflation continues to remain far lower than RBI’s projections, the Governor stated that "Incoming data is expected to provide greater clarity on the durability of recent food and non-food disinflation" and considers the impact of 7th Central Pay Commission HRA, rising rural wage growth and fiscal slippages due to farm loan waivers, as upside risks. In this aspect, we would like to point out that CPI, core CPI, and WPI figures have all been within the RBI’s inflation bandwidth since October 2016.

In addition, even if we account for such risks, it would still fall short of the inflation target band as the risk factors appear to be highly mitigated. We (IMA) believe, that becoming too over cautious is against the principle of prudence. Growth in industry credit has been contracting since Oct 2016, reflecting muted demand so far. In addition, components of aggregate demand reflect a slump in capital formation for the third consecutive month by -1.6% YoY.

Note: Monthly values for fixed capital formation (YoY%) has been calculated using Eviews

While we agree that in case of emerging markets like India, the standard prescription for monetary policy does not work very well, however, given the quiescent nature of private investment and credit crunch to the industries, warranting a rate cut is necessary to provide a fillip to demand and effectively stimulate the near-dormant investment cycle in the economy.