With the Fed meeting behind us, all eyes are on the Reserve Bank of India. There is certainly demand from many to cut interest rates. And we believe there is a compelling case for the RBI to do so later this month.
Comfort factors The primary reason is that most of the domestic pre-conditions outlined at the August review have been fulfilled. For instance, CPI inflation held below 4 per cent in July and August. The central bank had emphasised that it would look through distorted inflation readings in these two months but the slower-than-expected sequential pace probably took it by surprise.
Moreover, our estimates suggest that the impact of below-normal monsoon lasts for 3-4 months, implying that inflation will likely stay within 5-5.5 per cent through December. This gives comfort that inflation is easing and may likely stay in control. Secondly, better policy transmission should help. One example of increasing effect of policy decisions on end-users is in the banking sector.
To improve sensitivity of retail rates to policy changes, the RBI proposed a regulatory change whereby banks would need to consider marginal cost of funds to calculate lending rates. Such a move can better help transmit the intended effect in the market.
Finally, external risks have abated as the US Federal Reserve signalled the need for more convincing data to justify normalisation of interest rates there. The Chinese yuan has also stabilised. Hence, at this point there may be no immediate danger from external factors.
That said, the box that still has to be ticked is the government’s structural measures. These moves have hit a roadblock at the recent parliamentary session. Few supply-side measures have been fixed and bigger structural changes remain in the slow lane.
We expect the reform agenda to be re-visited after next month’s state elections. What it means is that the impact won’t be felt for some time yet.
In addition to these comforting factors, easing inflation gives the RBI room to cut rates further.
Inflation to deflation? Indeed, a debate is rising as to whether deflation might now be a bigger risk than inflation. This emanates from low GDP deflator inflation and a sharp decline in WPI inflation. The latter has fallen for 10 consecutive months to a record low of negative 5 per cent year-on-year in August. With CPI inflation at 3.7 per cent, the divergence is at an all-time high. Does the persistent negative reading on WPI points to a deflation risk? We don’t believe deflation is a large risk for two reasons.
Firstly, deflation is not only a price phenomenon but also reflects weak demand conditions. It typically involves corporates/ manufacturers persistently lowering prices to boost demand while households postpone purchases on expectations that prices would fall further, leading to a vicious cycle.
Higher frequency data indicators do not suggest that India is in the midst of such an environment.
Setting aside the 7 per cent headline growth numbers, underlying momentum is turning up. Industrial production growth has stabilised at around a 3-4 per cent pace, construction activity is picking up, credit growth is steadying, rural wages have bottomed and funding costs are set to ease. All these factors should boost investment, while consumption and confidence indices already appear to be on the mend.
Adjustments to salaries/pensions for armed personnel and Seventh Pay Commission next year for public-sector employees should also lift demand.
Secondly, lower commodity prices have played a part in dampening WPI inflation. Fuel and mineral prices accounted for over three-fourths of the fall in headline WPI in the last two months. Easing farm prices and trickle-down impact on manufacturers’ input costs have also contributed to lower inflation.
Finally, unlike CPI, the WPI ignores service sector prices, which are comparatively inelastic and more representative of underlying demand conditions. In short, we believe India is going through a phase of disinflation rather than deflation.
With inflation-targeting as the new policy tenet and the CPI as the main price barometer, recent soft inflation readings make a case for the RBI to lower rates by another 50bps by end-fiscal year.
External developments remain an important wildcard that could alter timing of the rate cut but not, we believe, by a great deal.
(The author is an Economist and Vice President, DBS Bank Singapore)