PRANJUL BHANDARI

THE RBI held on to its 5.1% CPI inflation forecast for JanuaryMarch 2017, but highlighted that there were upside risks now versus the scope for downside surprise last time. This is unsurprising since the RBI had mentioned in April that it expects CPI inflation to average 5.1% in FY16 with small inter quarter variation. Since then, the April CPI reading has come in 40 bps higher, domestic food prices have firmed up, and oil prices have risen 30%. Estimates suggest the wedge between RBI's oil price assumption ($40 per bbl) and where oil is trending now ($50 per bbl) can add 25bps to its year end inflation forecast.

Yet, timely and sufficient rains could ease food and overall inflation. We find that food prices are clearly sensitive to reservoir levels. Reservoir levels depend on carry-forward stock of water and current rains. This time around, the carry-forward stock is in deficit and hence early rains are even more important.

The policy statement highlighted that there was considerable uncertainty in the inflation outlook from precipitation, global commodity prices and implementation of the 7th Pay Commission pay hikes. In the same breath, however, the central bank also highlighted mitigating factors on the supply-side such as better food management and headroom in industrial capacity that could keep prices contained even as demand picks up.

The growth outlook was retained with recovery expected to be driven by stronger consumption and higher public sector capital expenditure. The latter is expected to crowd in private investment,andsomewhatoffsetthedrag emanating from financial stress, domestically, and weak growth, globally.

We agree that the recovery will largely be led by consumption. Also, higher consumption over time could reduce the overcapacity in the economyandincentiviseprivateinvestment.

However, this process is only likely to unfold over the next two years. For the next year, we expect growth to remain flat at 7.4%, lower than the RBI's estimate of 7.6%. While liquidity conditions have improved since the last meeting thanks in part to the RBI's bond and dollar purchases, market interest rates have hardly moved.