Space for more RBI rate cuts

SOFTER consumer inflation and over 50% slide in crude oil prices since June have convinced RBI that the momentum of inflation is waning. The Reserve Bank of India (RBI) has initiated an easing monetary policy cycle with a 25 basis point (or 0.25 percentage point) policy rate cut on 15 January, consistent with its guidance in the December policy statement. An intermeeting rate cut was mooted in that policy review with hints that a change in stance could come early this year.

The central bank followed up on that guidance with a rate cut two weeks ahead of the review due on 3 February. Softer-thanexpected consumer inflation (as measured by the Consumer Price Index, or CPI) in recent months, driven by broad-based disinflationary tendencies, particularly those related to core inflation and even food, combined with an over 50% slide in crude oil prices since June, have convinced RBI that the momentum of inflation is waning.

In fact, such has been the pace of decline in inflation that retail inflation at 5% in December was well below RBI's January 2015 target of 8%. Besides consistently easing inflation since July 2014, the fact that expectations of lower inflation are also setting in has finally given RBI the comfort to reverse its policy stance.

Household expectations of inflation have fallen to a single-digit level for both the near term and the year for the first time since September 2009. Noting these trends, the central bank now estimates that January 2016 inflation will be lower than its target of 6%. These favourable developments on the inflation front have created the space for easier monetary conditions in 2015 and more rate cuts to support growth.

How far will RBI go in this rate cut cycle? While its monetary policy stance has shifted towards supporting growth, RBI's focus on inflation remains, given the endeavour to implement a flexible inflation- targeting regime. On future rate cuts, the central bank remains cautious.

Along with inflation remaining soft and below its January 2016 target, continuing efforts from the government towards fiscal consolidation and ensuring adequate supply of key inputs including land, minerals and infrastructure have been listed out as the factors determining the timing and the extent of monetary easing. While a rate cut on 3 February looks unlikely, the focus will be on RBI's conditions for continuing with an easier policy stance.

Continuing correction on the fiscal front, especially in terms of an improvement in the pattern of government spending and efforts to address supply constraints will be necessary for rate cuts beyond another 50 basis points. The onus, therefore, remains with the government for ensuring a lower interest rate environment by ensuring fiscal and policy support for low and stable inflation.

The orientation of the budget for the next fiscal year will thus be an important guide for RBI's decision on the magnitude of rate cuts in this easing cycle. Considering that the broadbased disinflationary tendencies visible over the last couple of months are likely to persist over the next couple of quarters at least, another 25 basis point rate cut can be expected between March and April. Oil prices and even prices of industrial metals and agricultural commodities have fallen further in January. On oil, RBI is of the view that prices are expected to remain low over the year, barring any geopolitical shocks.

That will not only provide comfort on the future path of inflation, but also on keeping the current account deficit well within manageable limits despite a pick-up in non-oil imports, the exchange rate stable and the fuel subsidies bill lower.

Easing rural wage inflation over the last year will reduce the pressure on the food inflation front, too, though a normal monsoon this year is critical. The global environment also remains broadly supportive, especially as the quantitative easing by the European Central Bank will help negate the impact of normalization of rates by the US Federal Reserve.

With preference for real policy rates in the vicinity of 1.5-2%, the space for rate cuts may be constrained to another 50-75 basis points, unless inflation eases durably towards 5% or lower. However, given the lag in monetary transmission of policy rates into bank lending rates, particularly during a easing cycle, any further rate cuts are likely to be front-loaded in the first half of the 2015.