C16140 Sonal Varma2

Our India economists discuss their views on why the Reserve Bank of India (RBI) ought to keep rates unchanged in August 2017, but why a rates cut is still more likely. They expect “a one and done” scenario, where the RBI will have a prolonged pause after a potential rates cut in August.


We have a strong normative judgment that the Reserve Bank of India (RBI) ought to keep rates unchanged at its August monetary policy meeting given the uncertainty in trying to distinguish structural from cyclical factors this soon. Too many disruptions – the demonetization exercise earlier and now the implementation of the goods and services tax (GST) – are clouding the macro picture. Our baseline macro forecast is that both growth and inflation are headed higher in the next 12 months. Moreover, we believe the growth impulse from a token rate cut would be small compared to the important risk to the RBI’s credibility should circumstances later require a policy flip-flop.

However, the fact is that the RBI is under a lot of political pressure to cut interest rates in August given currently very low inflation, the disappointing Q1 GDP growth print and now a sharp drop in oil prices. Against this backdrop, we are changing our call. We now assign a 70% probability to a 25bp rate cut in August (30% probability on hold) and consider this “a one and done” scenario, with the RBI on a prolonged pause thereafter. We also remove our call for a 50bp rate hike in H2 2018 until more clarity emerges on the macro outlook.

Our analysts also lay out five reasons why they expect inflation to climb from here.


1.     The cobweb cycle

Negative food inflation mostly reflects temporary factors: the supply response to elevated prices (pulses), the demonetization exercise driving a glut in perishables, good monsoons (cereals) and base effects. Structural improvements in agriculture happen gradually, not suddenly. We doubt food inflation can remain below 4%. Our preliminary analysis suggests that the cost of farming, on average, is rising at around 4% per annum. If so, India is likely to experience a classic cobweb cycle, where farmers are forced to cut production and switch away from crops that do not assure a reasonable return, resulting in lower supply and higher prices later on. Farm loan waivers announced in Uttar Pradesh, Maharashtra, Punjab and Karnataka are also a sign that current low food prices are unsustainable. The two fundamental drivers of food inflation – minimum support prices and rural wages – have both been growing at a stable or rising rate at the national level.


2.     The economic rebound

We expect a V-shaped economic recovery in India. Disruptions caused by the demonetization exercise slowed GDP growth to 6.1% y-o-y in Q1 2017, but leading indicators are signaling that economic activity is recovering, underpinned by pent-up consumer demand, easier financial conditions, exports and public capex. Certainly there are still pockets of weakness, such as private investment and credit, but in our heat-map, 10 of the 16 indicators released so far for May are signaling stronger activity (Figure 1). We forecast GDP growth to rebound to 6.6% y-o-y in Q2, 7.1% in Q3 and 7.7% in Q4 2017, as strong rural wage growth, the lagged effects of easier financial conditions and state government pay hikes buoy consumption, while continued progress on supply-side reforms boosts public investment. All this should narrow the output gap, offsetting the current disinflationary pressure.


3.     GST in theory and practice

There is a considerable amount of uncertainty over the short-run impact of India’s first comprehensive GST, to be implemented from 1 July. The GST is designed to be progressive and our calculations of the changes in GST rates on all the CPI items suggest that on paper at least, it should be disinflationary if all the tax benefits are passed onto consumers. But in practice this may not ring true, due to firms’ asymmetric pricing responses, which tend to be more rigid on the downside but more flexible on the upside. We have studied the near-term inflation impact of the introduction of GST regimes in Australia, Canada, Japan, Malaysia and Singapore, and in all cases although the tax was introduced at a lower rate than the previous sales tax, inflation rose in all five countries, including in Malaysia which tried to more strictly enforce an anti-profiteering mechanism (see India: GST and its near-term inflation impact, 26 May 2017).


4.     Rental allowance increase

The rental allowance increase for central and state government employees is still pending and we expect an announcement regarding central government employees in July. It is a one-off move, so the impact will be temporary – lasting 12-18 months – but sizable, adding ~90bp to headline CPI inflation when implemented by the center and 100-150bp when implemented by both the center and states. We would expect the RBI to look through the one-time effect, but it needs to be wary of any impact it may have on longer-term inflation expectations.


5. Elevated expectations

The RBI has not yet won the war against inflation expectations. Household inflation expectations have moderated since 2015, but the one-year ahead mean expectation was still high at 9.2% in May 2017, above the 5-6% range seen during 2006-07. Given that expectations are adaptive, the rise in inflation due to the four reasons above could lift inflation expectations and push core inflation to ~4.5-5.0% next year, even though it is set to dip in the near term.


Read the full report for further insights into our analyst' views on India's monetary policy, normative versus positive view on the rates cuts, and general growth outlooks on various sectors of the economy.





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