Is there a rate cut round the corner? The decks are cleared, it seems, as inflation has cooled off and stayed aligned to the 4 percent target so far this quarter. While at a sustainable level, it would pave the way for easing the rates, there could be some headwinds, too.
Last week's retail inflation data showed that the consumer price index (CPI) based inflation remained largely the same as in the previous month at 3.65 percent in August. Even though this is partly due to the base effect, what is interesting to note here is that the inflation has averaged at 3.65 percent for the first two months of the second quarter. The RBI has forecast a 4.4 percent average inflation for the second quarter. Also, there is an encouraging signal from easing food prices. This should be music to the Monetary Policy Committee (MPC), which has been struggling to bring down inflation to the 4 percent target in a sustainable way.
Even if retail inflation moves up a bit in September with the fading of the base effect, on a whole for the second quarter, the inflation is likely to stay within the RBI’s average estimate.
Within the inflation numbers, food prices stayed elevated, with food inflation rising marginally to 5.7 percent from 5.4 percent in the last two months. While inflation in cereals, eggs, pulses, fruits and vegetables averaged above 6 percent, that in case of pulses singed at 13.6 percent. According to Madan Sabnavis of Bank of Baroda, one needs to wait for the new crop to come in before the prices cool off.
For the MPC, the trigger for a rate cut is a sustainable easing in inflation aligned to the 4 percent medium-term target. If the inflation continues to remain below 4 percent in September-November, the MPC could consider the first rate cut in December. But there are fresh challenges emerging.
The rising concern at this point is a likely rise in the core inflation number as input costs get embedded in prices. According to Sabnavis, this category would move up towards the 4 percent mark.
A bit of a surprise indeed, since in a growing economy, core inflation should be on the rise and can’t be falling consistently. When core inflation declines continuously and economic growth picks up, it makes an unusual situation.
So why is this happening? Madan Sabnavis, chief economist at Bank of Baroda, argued that companies, particularly those in the manufacturing space, have been refusing to hike prices for a long time since inflation was already too high. This resulted in a muted core inflation in the last one-and-a-half years. But this will start changing now as the manufacturers have begun hiking prices, he said. If the headline inflation stays closer to the 4 percent mark for a quarter or two, the MPC will have the room to cut rates.
The second big factor is the direction of interest rates in the world’s largest economy. This week, the FOMC is set to meet on 18th where it is widely expected this will mark the beginning of a rate cut. The broader expectation is that the Fed will start with a reduction of 25 basis points but an aggressive 50-bps cut cannot be ruled out. Typically, the RBI follows the US Fed rate cues. The recent comments from the US Fed indicates an early rate cut this year. When it comes to a rate rethink, the MPC is caught in its own trap. The panel has publicly, and repeatedly, said that reaching the 4 percent medium-term target is sacrosanct, before a pivot.
That means, if the US Fed cuts rates and if the MPC moves on rates before the 4 percent target is achieved in a sustainable manner, the panel will be embarrassing itself. On the other hand, if the MPC remains adamant on rate status quo for too long, it will be blamed for stifling growth and being over-obsessive on inflation. It will be interesting to know whether Das and his colleagues at the MPC would still ignore the US cues. Empirical evidence from the past shows the Indian central bank has typically followed the rate cues from the Fed.
If all goes on the expected lines, we should see the first rate cut in two years by December.
Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.
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