India’s retail inflation dropped to 2.99% year-on-year in April from 3.89% in March. Lower food price inflation and the so-called base effect played a role in taming retail inflation; besides, the non-food, non-oil core inflation too moderated in April. The consensus estimate for April retail inflation was around 3.3%.
The retail inflation in May, which will be announced a week after the Reserve Bank of India (RBI) unveils its bimonthly monetary policy on 7 June, may drop further—to around 2.25%, going by the most optimistic estimates.
Meanwhile, wholesale inflation too dropped to 3.9% on April from 5.3% in March, on a revised base year.
Nobody is expecting RBI to go for a rate cut later this week but against this backdrop, will the Indian central bank change the stance of its policy? If it does not change the stance—from neutral to accommodative—will it acknowledge that the upside risks for inflation are lower than what it had projected in April? Finally, if it revises its inflation projection for the fiscal year-end from 5% to 4.5%, it will be the icing on the cake.
The February policy signalled the end of the easy money regime which started in January 2015. During this period, RBI cut its policy rate by 1.75 percentage points in stages. The April policy was announced when the banking system was awash with liquidity and the overnight rates as well as all short-term instruments were trading below RBI policy rate.
In the policy, RBI raised the reverse repo rate or the rate at which banks park their excess liquidity with the banking regulator by a quarter percentage point to 6%, shrinking the liquidity corridor (with the repo rate or the rate at which RBI lends to banks remaining unchanged at 6.25%). In a liquidity-slush system, the reverse repo rate becomes the anchor rate and, by raising it, the RBI ensured that the overnight rate as well as other short-term rates would rise.
While the stance of the policy remained neutral in April, there was no indication of going back to an accommodative stance or a rate cut in the near future. The policy document and the deliberations of the Monetary Policy Committee (MPC) which were later made public made it pretty clear that the members of the committee were distinctly worried about rising inflation later this year for several reasons. At least one member of MPC believed that a pre-emptive 0.25% hike in the policy rate would help RBI to achieve its 4% inflation target but “on balance,” he voted for holding the policy rate unchanged and preferred to wait “a few more readings of incoming data” for a “clearer assessment” of domestic and global macroeconomic scenarios.
The concerns of MPC members were the following:
—The uncertainty surrounding the outcome of the south west monsoon in view of the growing probability of an El Niño event around July-August, and its implications for food inflation.
—The implementation of the allowances recommended by the 7th Central Pay Commission (the increase in house rent allowance for central government employees could push up inflation);
—The fallout of the goods and services tax (GST) coming into play in July;
—The impact of rising global commodity prices on domestic inflation because of the so-called pass-through effects.
The April policy also spoke about global growth suggesting signs of stronger activity in most advanced economies even as the outlook was gradually improving for emerging market economies. On the domestic front, it said several indicators pointed to a modest improvement in the macroeconomic outlook.
While there is no clarity yet on the impact of implementing pay commission recommendations, the latest trend in food prices is subdued and monsoon seems to be on its trajectory. GST may not have a big impact on inflation. While its exact impact on goods is still to be ascertained, the services sector will be able to neutralize the extra tax burden from benefits through input tax credit system. Most analysts believe that in the worst case scenario, the impact on inflation will be limited to 0.20%.
Global commodity prices have not been on an upswing; crude price has in fact declined; and, more importantly, the US Federal Reserve is less hawkish now than a few months ago. Finally, exports have been rising but India’s economic growth slowed to 6.1% in the fourth quarter of fiscal year 2017 from 7% in the third quarter even as the full year growth projection has remained unchanged at 7.1%.
All these are expected to make MPC members less hawkish in their approach to monetary policy formation. I would expect them to acknowledge that the upside risks to inflation are far lower now and the future course of action will be data-driven.
Flow of money continues to slush the system; the excess liquidity at this point is pegged at around Rs3 trillion but this may not be a big headache for the regulator. It is unlikely to raise banks’ cash reserve ratio (CRR) or even sell securities under the so-called open market operations (OMO) to drain excess liquidity. While CRR as an instrument is perceived to be permanent in nature, OMO pushes up the bond yield and increases the government’s cost of borrowing.
For foreign funds, India is an oasis. Where else will they get political stability, low inflation and high growth? The strengthening of the local currency—from around 68.20 to a dollar in January to 64.50 now—is a testimony to that. RBI will continue to intervene in the foreign exchange market; for every dollar it buys, an equivalent amount of rupee flows into the system. As long as the liquidity is not posing a threat to inflation, RBI will not be in a hurry to raise the policy rate. To drain excess liquidity, it can always sell bonds under the market stabilization scheme or MSS.