Inflation to avg at 5% in FY17; RBI may cut 25 bps in Dec: Pros

The Reserve Bank of India (RBI) has been working to bring down inflation to the 5 percent mark. Looking at the recent drop in food prices and base effect, experts believe that inflation can go down to 4 percent in December before rising slightly again. In a CNBC-TV18’s special show Citizens’ Monetary Policy Committee (MPC), headed by Pronab Sen, Country Director at IGC, had Sajjid Chinoy of JP Morgan, Samiran Chakrabarty of Citi India, Sonal Varma of Nomura and Saumya Kanti Ghosh of SBI as its members. Chinoy expects the inflation will average at 5 percent in 2017 while Citi has a target of 4.5-5 perecent for current fiscal. The panel also believes that the Reserve Bank of India has room for cutting rates in medium and long term. While the probability of a rate cut is slim in next four months, there are high chances of it in next 12 months, Sen said. Contrary to this, Citi and SBI believe that there is a 50 basis point chance of a rate cut while Nomura said that a 25 bps cut is expected in December. Below is the verbatim transcript of the interview to Latha Venkatesh on CNBC-TV18.Q: The near term inflation trajectory and the trajectory in 2017 as you see it.Sen: Well as of now unless things change dramatically, my sense is that inflation is going to be on a downward trajectory, fairly rapidly in the near future and perhaps little more gradually during 2017, but by and large the trajectory should be downward.Q: In 2017 when you say it will be lower are you expecting the average in 2017 to be 5 percent or even below 5 percent?Sen: I personally would think that by and large Indian inflation will hang around the 4.5-6 percent range, so where in that range it is going to be it is difficult to say, but my sense is Indian inflation will always be at the upper sort of range of the target.Q: Your trajectory for the moment for the rest of 2016 and better part of 2017?Varma: As far as the underlying inflation is concerned our view is that the inflationary forces which are coming from high expectations, the supply side constraints etc basically offset the disinflationary forces which is the weak rural economy, MSP etc, which have been low and negative output gap. As far as underlying inflation is concerned both for 2016 and 2017 we think it is going to be quite stable around 5 percent, if output gap starts to close which is in our view likely towards second half of 2017 then inflation starts drifting towards 5.5 percent, but that’s the underlying inflation. As far as the underlying is concerned the next 6 months or so do have positive base effects and few food prices have reversed quite sharply, especially pulses and vegetables as well and that’s going to bring down headline to under 5 percent 4 percent kind of a range at least in the next 3-4 months before it goes back to around 5-5.5 percent by March 2017.For the second half of calendar year 2017 we think there are upside risk to the to the headline from certain transitory factors one is the implementation of the goods and services tax, depending on whether the standard rate is 18 or 22 percent, we think that’s going to lead to inflation in the range of 20-70 basis point and second the house rent allowance increase under the Seventh Pay Commission is a statistical issue, but that still not implemented and it has an impact of almost 100 basis point on the headline and those two factors can push up headline in the second half of 2017, so fairly stable underlying, but headline coming lower in the near term and going up in the medium term.Q: But more importantly tell me whether the Reserve Bank will therefore be able to move towards the 4 percent January 2018 goal? Do you think that 4 percent goal is in danger?Chakrabarty: The way I look at it mostly the inflation trajectory in the near term is likely to be very soft, very similar to what others were also saying. We are more or less moving towards a 4.5 percent inflation economy, we were 6 percent earlier, 5 percent now probably moving towards a 4.5 percent inflation economy. The issue really is that how quickly do we want to go towards that 4 percent mark.The earlier framework to reach it by March 2018, but it appears from the new framework that the RBI is almost given a 5 year window to reach that. If that’s the case and there is no hurry to reach that 4 percent, then probably the entire monetary policy setting could be very different from what we were conceiving before.Q: But you have said that we are reaching a 4.5 percent inflation economy. What is your average for 2017?Chakrabarty: We are having something between 4.5-5 percent on an average, but that kind of builds in a bit of effect from the Pay Commission etc. So, if you take out that Pay Commission effects as one-offs then you are probably averaging somewhere around 4.5 percent.Q: First of all what is your 2017 trajectory and therefore how much space does the Reserve Bank have to cut rates?Ghosh: In terms of the inflation trajectory which we just mentioned median term is going to be extremely benign, you can see that is rapidly trending downwards because most of the prices are now being revert, pulse for example and also the vegetable prices, so you can actually see the inflation going down rapidly 4.5 percent possibly under 4 percent in December, but that’s also to some effect to the base effect, but if you go into the medium term, I also actually share the optimism that Indian inflation is now structurally rebounded from the high 7-8 percent and possibly to 5 percent or below 5 percent. So 2016 very soft pass downward trending December then inching up, but at the end of year we are looking at around 4.7 percent inflation or so and 2017 also. I don’t think it will structurally breakout closer to the range of 5.5 percent which we have seen earlier.Q: I thought you were giving me the impression that in 2017 like Samiran you are expecting it five and below five?Ghosh: Yes.Q: Clearly Dr. Sen and Sonal Verma are on the other side. They are expecting it between 5.5 and 6. So, are you saying below five. For a better part of 2015.Ghosh: Yes, exactly. The better part of 2017 will be below five, possibly the first half could see some numbers upwards of five.Q: But the average will be five or below five?Ghosh: Five or below five.Q: Which camp do you set?Chinoy: A couple of things here. The next six months the question is going to be will inflation undershoot their first intermediary target which is five percent my sense is it will, that you are going to see a U shaped trajectory for inflation, it probably goes down to four percent helped both by base effects and by food prices declining and you end up in the first quarter of next year somewhere between 4.5 to 5 percent which in a sense does open up some space for near term easing. One quick point I will make. On where is the medium term outlook for inflation there is clearly some structural part. We can't ignore the fact that despite two droughts food inflation in the last two years has averaged 5.5 percent vis-à-vis 11 percent the previous two years. So, no one can argue that the food disinflation is cyclical. There is a durable component to it which is going to pull the inflation trajectory down.The open question is what happens to core and the question is core momentum has been falling. In fact the last 3-4 months the momentum has fallen core is closer to five percent, the question is how much of that is cyclical because output gaps are negative and the rural economies depressed and how much of that is structural. That is the open question that the NPC will have to face up to in 2017. All told we look at an average of five percent next year.Q: Average of five percent calendar 2017?Chinoy: Yes, without assuming any impact because of one off factors like GST because we don't know what the rates are going to be and we don't know in the case of the HRA allowance whether it will be prospective, retrospective and what allowance is going to be. Taking those one offs away if you look at an average of five percent and you will find in the near term in the run up to March some space for easing will open up.Q: Let me come to the liquidity issue. The chances are the Reserve Bank of India will keep the liquidity extremely comfortable up until November because there is USD 26 billion flowing out. That is over Rs 1 lakh crore. That is a lot of money that will go out. So, they will keep it benign. Do you want them to continue to be benign up until March what kind of OMOs or dollar buying do you think they should indulge in?Chakrabarty: From the time RBI has moved towards this neutral liquidity framework, the transmission to market linked rates have been much better. The transmission to actual bank lending rate could be better than what it has been but we have to walk this path, we cannot now reverse the path. RBI has been pretty proactive in providing liquidity my sense is even during the FCNR(B) time whatever is the need for liquidity, that will be sufficiently covered by open market operations (OMOs).Once you get over this hump of the FCNR(B), you are probably going to rethink that from a very different perspective that how much of the full year\\'s net borrowing are we going to finance through RBI OMOs? Is there an upper ceiling on that number that is there on RBIs mind?Q: RBI told us that their overall liquidity is about Rs 1.5 lakh crore. In the previous meeting the governor said he is done with 60 percent. Chakrabarty: That would have given you about Rs 2 lakh crore number. So, that is almost 40 percent of the full years market borrowing. Now that is a pretty large number per se._PAGEBREAK_Q: You think the RBI will give that by March itself?Chakrabarty: The challenge really is that till about Rs 2 lakh crore there would be no surprise in the market. However if you go by the current trend in currency in circulation then the number can end up to be even higher than Rs 2 lakh crore and that is where the real challenge comes that will RBI go the full hog and get to 50 percent of market borrowing being financed by RBI, that is where I think things will become very interesting.Q: What is your advice, should they provide even if it means 50 percent of total borrowings? Of course they could be buying dollars as well?Ghosh: I think FCNR(B) redemption should be on the top of RBIs mind. However the good thing is that apart from the policy induced liquidity which the RBI has been providing in the last couple of months or so there has been an improvement in structural liquidity.If you look into the September and August data, 20 percent of the incremental deposits have come into the banking system for the whole year because of this pay commission recommendations and I think that number is upwards of around Rs 1 lakh crore.My sense is that they are going to do FCNR(B) because that also had a significant impact on the bond yields moving down, it is not purely because of the inflationary expectations and that has been the one good thing. More the yields move down the more it will be better for the banks to start transmitting at a scale which the markets may also want. So, RBI will continue to give liquidity at sufficiently positive level or neutral level so as to keep the transmission happening at a better rate.Q: The argument is that the RBI will keep liquidity plush, I want a specific number from you, do you think that the RBI will provide the balance Rs 1 lakh crore odd liquidity or Rs 1.2 lakh crore liquidity in the remaining six months? Also should they?Chinoy: I think everybody, perhaps the RBI as well has been surprised by the rapid increase in currency in circulation. We have written about this extensively in the last couple of months, we actually think it is linked to the rural economy.Just to put some numbers in perspective, two years ago currency circulation grew at about 1.5 trillion, last year it was 2.1 trillion, this year it is on course to being 3 trillion or more. So, I am not sure markets or policy makers expected this quantum of increase. However under the new framework the RBI is committed to a very simple fact - durable leakages like currency circulation will be matched by durable inflows. I think they would be agnostic about the choice of instrument. If they can do FX intervention, well and good, if not they will have to do OMOs.So, as long as rates stance is accommodative, as Pronab Sen said the liquidity stance will have to be accommodative as well to ensure that those rate cuts that we may project will get transmitted.Our expectation is that you may have to end up doing close to Rs 1.5 trillion of OMOs in the next 6 months.If there are opportunities for Fx intervention I think they will grab them to inject liquidity, if not they will have to do that as long as their rate stance is accommodativeThe relevant question is not whether they changed stance in December or March. The question is if the rate stance at some point in 2017 becomes neutral or cautious, then do you revisit the liquidity framework? That is the consistency I think that markets will look for.Q: We know that the policy preference from Delhi is that the RBI rather buy dollars, what is your sense, will RBI get the opportunity to buy dollars, how are you looking at the global scenario. Will it be as benign to let the RBI infuse liquidity through dollars rather than bonds?Varma: Global environment is quite benign. India is doing reforms to attract more flows, oil prices are lower, current account deficit is looking significantly under control, all which implies in our view that that this year's balance of payments surplus could be close to USD 30 billion. That basically means that RBI will have enough opportunity to actually do dollar buying unsterilized dollar buying in order to expand its balance sheet and I think it should choose that option.Q: How much space do you think there is for rate cuts over the next 12 months?Sen: Over the next 12 months quite a bit, over the next 4 months not so much. Q: If you could define it in the form of a number?Sen: What is going to be happening is that over the next four months you are going to have liquidity pressures coming in. We have talked about the FCNR(B) but the elephant in the room actually is you are going to have possibly the highest amount of grain procurement come November-December. That is going to soak out an enormous amount of liquidity from the system and we need to prepare for that. I don't think we are ready for it as yet. So, at this point in time a rate cut is probably not going to show up in terms of transmission and you would probably be better of waiting for the rate cut at a later point in time and do it gradually over the next year.Q: What is the sense of near term space for rate cuts and over the 12 month period?Varma: Like I said, our assessment of underlying inflation is around 5 percent and I think policymakers should be focussed on the medium term inflation outlook vis-à-vis their targets rather than base effects driven reversals and at around 5 percent inflation with still waiting for expectations to moderate, our assessment is that there is about a 25 basis point room.In terms of the timing currently our view is that December is more likely than October for two reasons one the FCNR (B) event will be behind us by October and second like I said core has been 5-5.2 percent for the last few months, so we would want to see that moderate before the Reserve Bank and also 25 basis point room we think December more likely than October.Q: Where will yields go in the near term and the longer term?Chakrabarty: We are looking for a 25 basis point rate cut in October and possibly even in December as well, so about 50 basis point of rate cut possibilities there and we think it can be front loaded because the kind of inflation risks that we were worried about earlier the known risks, the known risks have come down very drastically, so we have some visibility over the path of inflation and that should give us some scope for rate cuts.I think about 25 basis point of rate cut is already there in the price in the bond markets, if it goes to about 50 basis point of rate cut then commensurately you can see a little bit softening of the bond.Q: So the new 10 year is about 6.6 percent by the year end?Chakrabarty: That’s somewhere it should probably end up with if we get a full 50 basis point of rate cut, along with the comfort the whole structure is going to remain relatively accommodative and not changing very drastically.Q: How much space for rate cuts from now over the next 12 months?Ghosh: As of now we are factoring in another 50 basis point accommodative stance from the RBI and most possible it will be frontloaded because even though the FCNR (B) elephant is there in the room, there is another big elephant which could happen in December that’s the Fed rate hike and remember that the RBI December policy is on the December 6 that just comes one week before the Fed window, so I don’t whether the RBI will be doing a rate cut at that point of time, so 50 basis point as of now.Q: But over the next 12 months?Ghosh: Twelve months we are not factoring in much more maybe at most another 25 basis point, but 50 basis point looks the most plausible thing at this point of time.Q: First is cut or no cut?Varma: Pause.Q: Your vote?Chakraborty: There is a cut.Q: Your vote?Ghosh: There is a cutQ: Your vote?Chinoy: Hold.Q: Your vote on October 4?Sen: Hold.Q: What is their expectation of in terms of the amount of cut?Chakraborty: 25 basis point cut.Q: What is their expectation of in terms of the amount of cut?Ghosh: 25 basis point cut.