RBI rate decision may depend on three unknowns: GST, demonetisation and oil

In an about an hour from now, the Reserve Bank of India (RBI) will announce its third bi-monthly monetary policy for 2017-18, amid heightened expectations of a cut in the repo rate—its key lending rate.

On the face of it, conditions could not have been more conducive for a rate cut. India’s inflation rates have slowed to record lows and food prices have been falling. Consumer price index (CPI)—commonly referred to as retail inflation and RBI’s main guide for gauge economy-wide price trends—has moderated sharply to 1.54 percent in June, the lowest since the index was rebased to 2012 in a new data series.

Also read: RBI Policy Live Updates: Will the MPC oblige with a 25 bps rate cut?

Persistently low inflation levels often indicates weak economic activity, implying people are either putting off purchases or buying goods at a pace far slower than before. Latest data show factories are barely producing more goods.

Factory output – a good indicator of both industrial activity and mood of shoppers – crawled at 1.7 percent in May. The manufacturing sector, which accounts for 75 percent of total factory output measured by the index of industrial production (IIP), fared even worse growing 1.2 percent during May.

Data from other sources also seem to suggest that a missing bustle on factory floors. According to the Nikkei India Manufacturing Purchasing Managers' Index (PMI), manufacturing activity in Indian factories slowed to an eight-year year low in July, partly pulled down by drop in new orders and output following the rollout of the goods and service tax (GST).

How GST Will Change Your Life

The PMI, a metric to measure industrial activity capturing output to sales, fell to 47.9 in July, from 50.3 in the previous month indicating faltering business conditions. A reading below 50 indicates contraction in factory output.

The RBI and the government has set a retail inflation target of 4 percent for next five years with an upper tolerance level of 6 percent and lower limit of 2 percent. Given that inflation levels have reached alarmingly below the 2 percent floor, experts have been arguing that a rate cut was almost a done deal.

That said, there are three unknowns on the inflation front: Demonetisation, Goods and Services Tax (GST) and fuel prices.

The central bank also has to deal with a problem of plenty.

RBI Credit Policy: How Interest Rates Work

The unexpected surge in demonetisation-induced liquidity, and the subsequent flight out of funds from bank accounts has upset many banks’ asset-liability math.

Only two days ago, State Bank of India (SBI), the country’s largest bank, cut the interest rate on savings accounts with balance of up to Rs1 crore by 50 basis points to 3.5 percent, citing falling inflation rates and high high real interest rates as the main reasons behind the move.

SBI has argued that its incremental cost of funds was going up as 60 percent of demonetization deposits have flowed out.

If it had not cut savings rate, it would have had to raise the marginal cost of funds-based lending rates (MCLR)—the key determinant for final consumer lending rates. A cut in the savings rate would, it is expected, will reduce incremental cost of funds, eventually leading lower lending rates.

The second impact of demonetisation is on inflation. The deflation in food prices this year could, however, be structurally different from earlier glut years. The sudden flush out of high-value notes may have weakened farmers’ elbow room in mandis this year to negotiate better prices.

The current price crash could be partly due to a bumper winter-sown crop that have flooded mandis. With few buyers, the glut has forced farmers to dump products at throwaway prices to clear up a piling mount of vegetables.

It is quite likely that bulk buyers used demonetisation and restricted cash as an alibi to give farmers a “take or leave it” kind of offer in wholesale markets, offering a fait accompli of sorts to get rid of vegetables that would otherwise perish.

The RBI will also keenly look at GST’s impact on prices and how it will likely to play out over months in an economy characterised by multiple pain points.

Under GST, all goods and services have been placed under four slab structure – 5, 12, 18 and 28 percent – along with a cess on luxury and demerit goods such as tobacco, pan masala and aerated drinks. Most services, except those in the negative list of essential services such as healthcare and education, will come under GST.

Ahead of GST’s roll out from July 1, the country was in the middle of the biggest one-off sale season ahead of goods and services tax (GST) as nervous traders tentatively prepare to transit to the new tax system. A mid-year switchover to GST have prompted anxious shops to de-stock and clear up the inventory pile.

While prices of some products such as few car categories have come down, many services seem to have got costlier, a trend that may raise household cost of living. Also, the RBI and six member monetary policy committee (MPC) may choose to observe the inflationary impact of GST for some more time before pressing the button on more rate cuts.

The RBI will also likely keep one eye on the fuel prices front.The Organization of the Petroleum Exporting Countries (OPEC) has pledged to restrict output along with other non-OPEC producers, including Russia, by 1.8 million bpd between January this year and March 2018.

While oil prices fell on Wednesday, with rising US fuel inventories, a cutback by OPEC and the resultant fall in supplies should push up crude oil prices from its current historic lows, eventually leading to higher diesel and petrol pumpgate prices in India.

This, in turn, could fan the overall inflation rates, limiting the RBI’s ability to cut interests further.