For a central bank in an “accommodative mode”, these three, in our view, should be sufficient in its bid to support economic recovery. Following the 25bps action, the RBI will have delivered a total of 100bp in rate cuts, taking the policy repo rate to its long term average of 7%. With a 12-month transmission lag, it is hoped that if 2015 was the year of rate cuts, 2016 will be the year of transmission into lower lending rates, providing some support to growth.
The second condition of sufficient monsoon outturn, while not technically met, is not yet posing a huge problem. Rains have been 13% below normal, but the intriguing web of its spatial and regional distribution, together with soft global commodity prices and nimble steps on food supply back home, have helped keep a lid on generalised price rises, at least thus far.
The third condition of impact from Fed action stands good for now. With the Fed staying on hold in September, pressures on emerging market currencies have eased, providing a window for the RBI to cut rates.
For a central bank in an “accommodative mode”, these three, in our view, should be sufficient in its bid to support economic recovery. Following the 25bps action, the RBI will have delivered a total of 100bp in rate cuts, taking the policy repo rate to its long term average of 7%. With a 12-month transmission lag, it is hoped that if 2015 was the year of rate cuts, 2016 will be the year of transmission into lower lending rates, providing some support to growth.
Having said this, what is getting increasingly complex on the sidelines, is the macro-economic mix and outlook. These may have implications for RBI’s commentary and future stance.
The macro brew is getting stranger
Monetary policy making is getting trickier. Inflation and growth, the two variables RBI monitors are imparting confusing signals. For instance, consider these –
On inflation –
Divergence in food and core inflation: Till a quarter ago, food inflation was falling while core inflation was high and sticky. In a complete flip-over last month, food prices have inched up sequentially while core inflation is receding (see chart 2). So far the increase in food prices has been concentrated on specific items (like onion and pulses), but we continue to monitor a strengthening El Nino just in case it causes more havoc into next year. In the meanwhile this chance negative relation between food and core, is making a call on their net impact and thereby inflation forecasts a tad tricky.
Service inflation conundrum: One commonly held reason for the divergence between WPI (falling 4.95% y-o-y in August) and CPI inflation (rising 3.7% y-o-y in August) is that the latter includes the non-tradable services sector, which tends to have higher inflation, while the former does not.
This argument held well until we got the April-June quarter GDP data. The services sector deflator contained within GVA fell 0.5% y-o-y. On the other hand, headline CPI and core CPI inflation around the same time were growing at a higher clip of 5.1% and 5.6% respectively.
So now it seems there is some divergence, even within the service sector. Some services are more tradable than others (see chart 3). And perhaps, services used squarely by final consumers are more inflationary than those used by the rest of the economy. This again, makes the job of inflation forecasting a notch harder.
On growth –
Indirect tax up, but direct tax down: Indirect taxes have grown 35% y-o-y in the April-July months. The government estimates that even after scrubbing off changes in tax rates, it grew at a healthy clip of 14.6% y-o-y. But if this is a sign of healthy recovery, why are direct taxes only growing 1% y-o-y during the same period (see chart 4). There are no clear answers …
Urban vs rural consumption; private vs. public investment: who wins? The remains from the tug of war between improving urban consumption and languishing rural demand will be a key determinant of overall economic growth (see chart 5). On investments, the strength and sustainability of public investment whilst private investment is lacklustre will be a determinant of not just growth but also medium term inflation.
Next year’s impossible trinity: Switching from current expenditure to capex has been a laudable step taken by the central government this year. But come next year, with its 7th pay commission commitments, one of the three objectives - fiscal consolidation, higher capex and a higher wage bill - may have to give. If it is capex, then the switch back from capex to current spending would have implications for both growth and inflation. This will have important bearings which RBI would need to start accounting for from now, given transmission lags.
Why a change in stance is in order …
Given these confusions and uncertainties, often times typical of recovery episodes, RBI will have to tread carefully. Since pressures on inflation and growth exist on both sides, and the RBI has lent a helping hand to growth through 2015, the central bank may be well placed to shift to a balanced stance at this juncture.
The move from an accommodative to a balanced mode will also help the RBI brace for its next big target: 5% CPI inflation by beginning 2017, a time during which economic growth is expected to pick up pace, putting pressure on core prices. This would require further disinflation in the system given underlying inflation (taking off base effects) is currently at the 5-5.5% range.
The shift towards a balanced stance is likely to be reflected in the policy statement by extending the inflation fan chart to beyond March 2016 and more discussion on the challenges and prospects of deflating the economy towards 5% inflation. We expect the RBI to go on a prolonged pause following the 29 September meeting.
Pranjul Bhandari, Chief India Economist
Prithviraj Srinivas, Economist
Source: HSBC
