Global situation not conducive to cut

The RBI’s decision to stay pat on the policy rate might have disappointed the majority in the markets who had expected a cut in rates in response to a slowdown in growth that the cash crunch brought. But perhaps there is method in the madness and one could look for a clear rationale for the RBI’s inaction.

But first things first. On the domestic front, the full impact of demonetisation on growth and inflation, and the relief from remonetisation (the pace of cash replenishment) is yet to be gauged with any degree of accuracy. On the global front, the Trump presidency and political shifts in Europe could redefine both US fiscal and monetary policy and the structure of global trade.

Emerging markets and their currencies including the rupee are bound to feel the impact of this. The global commodity cycle too seems to have turned with the supply cuts planned by the OPEC (pushing oil prices up), and because of the expectation of a large fiscal stimulus in the US driving a base metal rally.

The central bank grappled with another risk in its choice of the policy rate level and the guidance it offered. It is possible that a rate cut could have strengthened apprehensions of a sharp slowdown in the economy. Thus instead of explicitly acknowledging a marked slowdown, the RBI chose to play growth concerns down by keeping the policy rate on hold. The RBI’s bet at this stage seems to be to convince the market that growth pain is transitory while there is enough demand in the system to make it fret over inflation risks. This strategy is certainly unconventional, if not bold but whether it works is the key question.

We also suspect that the impending rate decision by the Fed has influenced today’s policy in that it has put the RBI in a ‘wait-and-watch’ mode. The argument that the expectations of a rate hike are all priced in is fine but the actual unfolding of a major event like the Fed policy has been known to rock markets.

Moreover, it is not just the rate hike in December but Fed’s guidance for 2017 which could keep the markets guessing in the near-term. Thus going by the textbook, keeping rates unchanged was perhaps the optimal course of action.

The RBI revised its 2016-17 GVA forecast from 7.6 per cent to 7.1 per cent on account of a somewhat tepid first half for the year and expected marginal loss of growth momentum in the second half of FY17. It argued that while the adverse impact of demonetisation would wane, there would be positive offset from the boost to consumption demand from higher agricultural output and the Seventh CPC awards. That said, it conceded that it is important to analyse more information and experience before judging the full effects of demonetisation. In our view, the downward revision in growth was rather modest. We see the prospect of the GVA forecast being revised lower early next year. If there were to be a sharper moderation in economic growth in 2H-FY17, the RBI could cut policy rate in order to speed up the recovery process.

On the inflation front, the RBI highlighted the upside risk on account of rising oil prices. While it acknowledged that the compression in demand (related to demonetisation) could shift inflation lower by 10-15 bps, it argued that the upward momentum in prices of wheat, gram and sugar alongside the resistance in core inflation could a set a floor to the headline inflation.

Overall, the RBI said that headline inflation is projected at 5 per cent in Q4 of 2016-17 with risks still tilted to the 'upside'. While we agree that the deflationary impact of demonetisation is likely to be modest, the upside risk on account of oil and other factors might not be as severe as the RBI seems to have factored in its policy calculations.

Internal growth-inflation dynamics are favourable for more rate cuts —at least 25 bps in the rest of the year. But could the cuts be more aggressive?

Clearly, there are global factors that could still weigh and limit an aggressive cut going forward. As the RBI said in its policy statement, the imminent tightening of monetary policy in the US is triggering bouts of high volatility in financial markets, with the possibility of large spill-over that could have macroeconomic implications for emerging markets.

India cannot afford to delink its interest rate trajectory completely from the US without risking capital outflows. We also cannot ignore the fact that the global commodity price outlook is far less benign than the last couple of years and some caution from the central bank is warranted. These factors could mean that too many more rate cuts might not be in the offing over the medium term.

Barua and Arora are chief economist and senior economist, respectively, at HDFC Bank