Economic, financial conditions increase chance of a repo rate cut

The full Monetary Policy Committee will reportedly meet to decide actions at the next bimonthly review. Current and expected economic and financial conditions suggest there is a betterthan-even chance of a repo rate cut.

Financial conditions have eased significantly since the change in the Reserve Bank of India (RBI)’s liquidity framework from April 2016 with the benchmark overnight call rates staying within a narrow band of the repo rate. Current indications are that foreign currency inflows are likely to help support system liquidity. The US Fed’s hold decision, together with a more dovish tone, and a conservative slant to the major central banks’ policy positions augurs a period of relative stability for financial markets. This will help smooth India’s FCNR redemption process. Consequently, the rupee is likely to remain stable in the near term, with near-term forward rates also having fallen.

The growth-inflation tradeoff still remains consistent with an easing stance. Growth remains weak, although aggregate demand is likely to gradually improve, originating in the good monsoon-fed agriculture sector and diffusing into the rural services ecosystem. Capex will depend largely on public spending but indications are that recovery will be very gradual.

The decision to cut the repo rate will hinge dominantly on the view on inflation. Over the next few months, CPI-based inflation is likely to drop, (to less than 4.5 per cent in November 2016), and meet RBI’s forecast of five per cent by March next year, under some reasonable assumptions. However, are there now structural trends consistent with a longer term alignment of inflation with the four per cent target? It appears the average CPI-based inflation in FY18, one year from now, will be around 4.3 per cent. But, there are risks to this view. Inflation expectations still remain fairly sticky. If we add the effects of the Seventh Pay Commission-recommended HRA increases, the initial effects of a reasonable GST (goods and services tax) standard rate, the progressive diffusion of the salary increases to state government employees and a slight rise in crude oil and commodities prices, we might see a 0.6 – 1.0 per cent increase in the inflation rate over the base. However, some of this is likely to be a one-off rise, amenable to a see-through. Capacity utilisation remains low, inhibiting pricing power.

By RBI’s own metric, the neutral (interest) rate is the real oneyear ahead T-bill rate at around 1.5–2.0 per cent, which given historical spreads, translates to a 1.0–1.5 per cent real repo rate. The expected growth and inflation trajectories over the next few months might open up room for RBI to gradually cut the repo rate to around six per cent. MONETARY POLICY REVIEW