Softening inflation, coupled with signs of a domestic slowdown and fresh global jitters have raised the odds of the Reserve Bank of India (RBI) loosening its monetary policy stance in October by introducing another rate cut, a move which could bring cheer to Dalal Street that has succumbed to panic and fear in recent days.
In what will be his first meeting as the head of the country’s central bank, Urjit Patel could deliver an early festive season gift to Asia’s third biggest economy by unveiling a 25 basis points cut in the repo rate, on October 4, 2016. His predecessor, Raghuram Rajan had refrained from tinkering with borrowing costs in his last meet in September, keeping the repo rate unchanged at 6.5 per cent, citing high inflation risks.
Lower inflation paves way for October easing
However, the sharp retreat in consumer inflation to a five-month low at 5.05 per cent in August 2016 from 6.07 per cent in July 2016 would be music to the ears for Patel, who like Rajan, is known to be an inflation hawk. Retail inflation, the RBI’s benchmark price gauge has now fallen below the tolerance level, leaving leeway for a reduction in policy rates. The government had recently notified an annual inflation target of 4 per cent plus or minus 2 percentage points.
Perhaps the most pleasing thing to emerge from the August inflation data is the moderation in prices of food items. It must be noted that the share of food in the CPI basket is close to 47 per cent. From a high 8.4 per cent in July, food inflation softened to 5.9 per cent in August as vegetable prices eased. Prospects of a bumper harvest amid a good monsoon may keep gains in food prices under wraps, ensuring that the RBI’s 5 per cent inflation target is met by March 2017, making the case for a rate cut.
However, there is one little thing that the apex bank may be a tad worried about when it meets next month. Pay hikes owing to the 7th Pay Commission recommendations may push up domestic demand and exert upward pressure on inflation. This factor may keep the rate cut restricted to 0.25 per cent.
Investment at a low ebb- a good reason for the RBI to act
Tepid investment has taken some sheen off India’s fastest growing economy tag, with economic growth hitting a six-quarter low of 7.1 per cent in the April-June period. While the government is doing its share in reviving sentiment by making progress on key reforms such as the GST, a move to lower the cost of funds for India Inc. is vital to rejuvenating the investment cycle.
A surprise contraction in July industrial output is evident of underlying weakness in the economy and has dashed hopes of a sustained demand turnaround. The 2.4 per cent contraction in July IIP was the biggest in eight months, contrasting June’s 2.0 per cent rise. Production of capital goods, a proxy for investment demand, shrank by a whopping around 30 per cent in July, leading to a 3.4 per cent contraction in manufacturing output.
Weakening global conditions means RBI needs to prop up domestic demand
As central banks worldwide start to raise eyebrows over the impact of ultra-loose monetary policy regime, uncertainty over monetary outlook in key economies has shaken & stirred global stocks, wiping off some USD 2 trillion worth investor wealth last week.
Even if the US Federal Reserve doesn’t choose to raise interest rates next week, it may very well do so in December, with many officials indicating the urgency to tighten sooner rather than later as the labour market continues to show improvement. Whilst the world’s top central bank moves towards raising rates, the European Central Bank (ECB) has played down the prospect of further stimulus even as growth and inflation remain feeble in the 19-member Euro area economy, making investors jittery. The Bank of Japan is undertaking a comprehensive assessment of its stimulus program, a sign that monetary policy may have run its limits in boosting growth.
Reduced prospects for global monetary stimulus coupled with uncertainty over who will emerge on top in US Presidential elections in November, a continued China slowdown, prolonged weakness in oil prices, Brexit impact means that the global economy is sailing on rough seas, urging the need to bolster domestic demand by cutting interest rates.
With a record high forex reserves kitty, shrinking current account deficit and strong growth fundamentals, India is likely to withstand any volatility in capital flows on account of a worsening global gloom, keeping the rupee strong, meaning that the RBI can proceed with its accommodative monetary stance.
The Bottom line– The case for a rate cut in October is quite strong as an investment flop show, easing price pressures and darkening world economy demand a further relaxation of monetary policy. Looks like Urjit Patel will oblige!