‘There is room for a 25 bps rate cut’

The June monetary policy meeting came against the backdrop of a sea change in the perception of future inflation trajectory.

There were widespread expectations that the central bank would acknowledge the recent trends in the Consumer Price Index (CPI). The policy resolution did not disappoint in this regard and the FY2018 trajectory was revised significantly downward.

Earlier the message from the RBI was that of difficulty in achieving the 4 per cent CPI target on a durable basis. The minutes of the meeting also had one member of the Monetary Policy Committee (MPC) contemplating a pre-emptive rate hike. The scenario has now clearly changed and space for further accommodation has opened up, albeit subject to incoming data.

This expectation is further reinforced by the fact that the sluggishness in private investment is adversely affecting growth prospects and all manner of policy support would be required to rejuvenate the proverbial “animal spirits”.

What has led to such a significant shift in policy expectations in the space of just two months?

If we were to analyse the factors prompting this change they’re mainly twofold.

Firstly, CPI inflation for the month of April has surprised substantially to the downside. The surprise was fairly broad-based but more pronounced for food inflation. The usual pre-monsoon rise in sequential food momentum seems to be at bay this time, which led to a sub-3 per cent YoY headline print.

Encouragingly, core inflation, which excludes the more volatile food and fuel, also surprised on the downside. Some of these softening trends could be on account of some residual demonetisation-induced effects as well and hence the trend in sequential momentum over the next few months will be crucial to track.

The RBI reduced its inflation forecast to 2-3.5 per cent YoY for the first half of FY2018 from 4.5 per cent earlier and 3.5-4.5 per cent YoY for the second half from 5 per cent earlier. While the quantum of revision is surprising, it is now in line with broad market expectations.

Our own view on the inflation path indicates that average CPI for the whole year will comfortably remain significantly below the RBI’s target of 4 per cent. Other developments show that household inflation expectations have shifted sharply lower in May as compared to March levels.

Secondly, on growth, it was heartening that the RBI explicitly acknowledged the fact that private investment demand needs all manner of policy support as it continues to adversely affect growth. The recent GDP data released last month showed a sharp deceleration in growth and the internals showed that already weak economic activity was supported mainly by agriculture and government spending.

Add to that the fact that capacity utilisation rates remain fairly low, which implies that the economy’s output gap is not likely to close very rapidly and the aggregate demand recovery will be more gradual and skewed mostly on the part of consumption rather than investment. This means that any upside risks to core inflation are also likely to remain contained.

A combination of these factors suggests that a suitable environment has been created for further accommodation and MPC members also acknowledged this fact. The RBI’s assessment of optimal real rates also implies that if the CPI trajectory plays out as expected, then the space for accommodation could increase further.

However, we feel that the RBI will remain cognizant of a host of risk factors which could come into play. It has also emphasised the fact that monetary policy effectiveness is predicated on other urgent requirements as well, such as resolution of the bank balance sheets, infrastructure creation and reining in general government deficits. Apart from this, central banks are usually more likely to err on the side of caution, especially while targeting headline inflation.

Weighing these factors in balance, we believe there is room for a 25 bps rate cut, may be as soon as in the next policy meeting.

Other measures, including regulatory steps in the form of reduction in SLR rate and easing capital requirement norms for housing loans, are welcome. These will help in improving the operating environment for the banking system and will also help in boosting credit flow.

On the markets front, long-term bonds will continue to react positively to evolving inflation trajectory, which is expected to remain benign for the next few months with increasing expectations of accommodation. On the other hand, systemic liquidity will be monitored as well, especially in the light of falling pace of currency leakage although the recent reverse repo hike has set some kind of floor. So the curve is likely to continue flattening.

The rupee has remained fairly supported for the past few months on strong capital flows and the favourable external environment is expected to continue to provide support, barring any extreme global tail risk event.

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

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