Moneycontrol
Jul 16, 2017 11:37 AM IST | Source: Moneycontrol.com

Low inflation may prompt RBI to cut rates in August, but with a cautionary commentary

Most experts expect the central bank to cut the repo rate by 0.25 percentage points to 6 percent on August 2, but without lifting the steadfast focus on cooling inflation

Low inflation may prompt RBI to cut rates in August, but with a cautionary commentary

Nikita Vashisht

Moneycontrol News

Historic low Inflation rates and shaky industrial activity has triggered hopes that the Reserve Bank of India (RBI) will cut interest rates in its monetary policy review on August. This has raised expectations about cheaper loans to spur consumer spending and corporate investment.

Latest price data released Friday showed that wholesale inflation slowed to 0.9 percent in June, the lowest in a year. It was 2.17 percent in May. Consumer price index (CPI) or retail inflation, the metric that RBI tracks for interest rate decisions, also decelerated sharply to 1.54 percent in June, primarily driven by falling food prices.

Industrial activity, on the other hand, has remained sluggish. Factory output, measured by the index of industrial production (IIP), grew at 1.7 percent in May, against 3.1 percent in April.

Business leaders have been ratcheting up their demand for lower interest to lower companies’ capital costs and aid capacity expansion plans.

“In view of the fall in consumer durable growth, reducing interest rates would help in stimulating demand and also reviving investments”, A Didar Singh, Secretary General of industry body Ficci said.

Consumer durables output shrank (-) 4.5 percent in May, compared with 7.4 percent jump during the same period last year and a (-) 6.0 percent fall in April.

In the last two monetary policies in April and June, the RBI kept the repo rate—its key lending rate—unchanged at 6.25 percent. The six member monetary policy committee (MPC), headed by new RBI governor Urjit Patel, chose to ignore calls from business leaders for cheaper loans to push investment and household spending.

Also read: Here’s why low inflation may not be a good sign

The panel, wanted low inflation to persist longer, before the central bank decides to cut rates.

Most experts expect the central bank to cut the repo rate by 0.25 percentage points to 6 percent on August 2, but without lifting the steadfast focus on cooling inflation.

“We are looking for a cut of 25 basis points (0.25 percentage points),” said Suvodeep Rakshit, senior economist, Kotak Institutional Equities.

The RBI and the government have set a retail inflation target of 4 per cent for the next five years with an upper tolerance level of 6 percent and lower limit of 2 per cent. Given that retail inflation is well below the 2 percent acceptable floor, experts expect the RBI to cut rates, but with a cautionary commentary.

“There normal stance is not going to change,” he said, adding that RBI “might cut rate but continue to remain cautious and keep neutral stance”.

Low inflation levels can indicate poor demand and weak economic activity, and this may well be the right time to lower borrowing costs that will goad companies and households to spend more.

The RBI and the MPC will be primarily guided by trends in what economists call `core’ inflation, or inflation in non-food, non-fuel categories. Persistently low core inflation is often seen as a sign of tepid demand that may warrant a policy action in August to fan activity in the broader economy.

“The momentum in the core inflation remains subdued,” said Upasna Bhardwaj, vice president, economist, Kotak Mahindra Bank. “Core inflation trajectory was something which RBI said was sticky… sustenance of weak core inflation is a reflection of underlying weak demand side pressures in the economy that will prompt RBI into action in the August meeting”.

Analysts and RBI watchers will also be looking for forward looking cues in the accompanying note on what the central bank thinks about the current economic situation and prospects in the coming months.

In the last monetary policy the MPC was categorical in stating that it would rather maintain a status quo wait for low price trends to continue, instead of reducing rates and then be forced to reverse it quickly if inflation starts galloping again.

“Premature action at this stage risks disruptive policy reversals later and the loss of credibility. Accordingly, the MPC decided to keep the policy rate unchanged with a neutral stance and remain watchful of incoming data,” it had in its June policy review.

Most analysts feel lowering rates is a necessary condition to revive investment. Capital goods output—a proxy for investment activity—shrunk 3.9 percent in May, from a 13.9 percent growth in the same month last year.

“The problem lies with the investment cycle and hence with the growth part,” Rakshit said.

“When the stem growth is weak and investment is missing… the focus should be on supporting investment,” Bhardwaj said.

The RBI will also likely be guided by effects of two other variables: increased house rent allowances (HRA) for five million central government employees and US Fed rate movements. Greater HRA could have an inflationary impact as people spend more with more money in hands.

Higher interest rates will make the US markets more attractive for foreign investors. This could prompt funds to move quickly from emerging markets such as India to the US in expectation of higher returns in the months to follow. This could knock down the rupee, making the RBI hesitant to cut interest rates to maintain India’s attractiveness as a favoured debt market for foreign funds.

“I am not anticipating any rate cut,” said Dhananjay Sinha, economist, Emkay Global Financial Services.

He said that the fall in inflation was partly due to demonetisation and that the economy might see an upsurge in prices once the process of remonetisation is completely done. “The medium term inflation is towards upside”.

“There is not too much room for easing,” said Bhardwaj.
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