Scope for further rate easing limited

However, there could be surprises this year, depending on the actual inflationary trend

The July monetary policy was set against the backdrop of the Monetary Policy Committee (MPC) revising its inflation trajectory significantly lower in the previous meeting, thereby building expectations of a rate cut. The MPC broadly stuck to the script and administered a 25 bps cut in the repo rate while retaining the neutral stance even amidst the clamour for a deeper rate cut.

Along with the fact that the policy outcome was on expected lines there was a significant departure in the rhetoric as well. The RBI acknowledged that previously expected upside risks to the baseline inflation path had not, in fact, materialised and that in the absence of the house rent allowance impact, the Q4 2018 inflation outcome could well have been lower than 4 per cent.

We take comfort from the fact that current market expectations about inflation are broadly in line with the MPC’s estimates. Some of the key factors that are likely to impinge on the inflation trajectory, going forward, merit detailed discussion.

At the outset, the MPC has chosen the approach of a prudent, inflation-targeting central bank to segregate the impact of structural and transitory factors for want of more data.

Moreover, for any central bank in emerging markets with an inflation mandate, the case to “err on the side of caution” is strong and leads to well-calibrated policy moves.

The implementation of house rent allowances as per the 7thPay Commission for States is, as of now, a wild card and the cumulative impact is not clear. The RBI estimates the impact of states to be around 100 bps over 18-24 months but our own estimates suggest a lower impact in the light of staggered implementation by the States.

The MPC also expressed concern about near-term price pressures building in vegetables and animal proteins. Prices have indeed gone up significantly over the past few weeks but may see some cooling once fresh supplies come into the market.

The government’s decision to keep MSP increases muted and the significant buffer stocks which we now have for cereals and pulses will also help to keep food prices under control.

Apart from the above, any price related impact of Goods and Services Tax (GST) implementation are difficult to ascertain at the moment and hence could be a key source of uncertainty to the baseline inflation trajectory.

On balance, our own expectations of the inflation path as well as the MPC’s path sees Consumer Price Index (CPI) ending at slightly more than 4 per cent by Q4 2018.

What does this mean for further policy action?

The MPC has now become more data-dependent and further accommodation will be a function of how inflation pans out. The other factor to consider is the issue of real rates. Given our March 2018 inflation expectation, real rate for India is slightly above 1.75 per cent, which seems to be more or less in line with the current thinking of the MPC as is evidenced by the Deputy Governor’s response in the post policy interview.

On a related point, the MPC’s policy setting and consequently the real interest rate also necessitates a delicate balancing act between the savings and investment objective of the economy. The MPC has to be cognizant of the fact that the rate is not too high so as to crowd out investment and at the same time ensure that returns to savers are not compromised.

In light of the above, the MPC’s calibrated approach in setting policy rate and evaluating the inflation path is welcome. At the moment the scope for further easing seems limited but space could open up sometime during the rest of the year depending on how the inflation path actually evolves.

As far as markets are concerned, the real rate remaining on the slightly higher side will continue to bolster confidence in Indian assets among the global investor community and robust capital flows will further support the rupee, even allowing for intervention by the RBI.

On the rates front, the 10Y yield is likely to remain in the 6.40-6.60 per cent range over the next few months and market action is likely to become more tactical in nature. Inflation prints along with developments in global monetary policy and evolution of commodity prices will be tracked closely.

In an allied development, the proposed extension of the MSS ceiling will probably obviate the need for any further open market sales by the RBI and hence the curve may not steepen as much as previously anticipated.

The writer is Group Executive, Head- Global Markets Group, ICICI Bank

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