RBI to defer a 25 bps rate cut to December meeting: ICRA

Aditi NayarAs we had anticipated, the Reserve Bank of India (RBI) retained the repo rate at 6.5% in its third bi-monthly monetary policy statement for 2016-17, with the firming up of inflation in Q1 FY2017 leaving little room for a rate cut in the August 2016 policy.  In line with the previous policy statement, the RBI described its monetary policy stance as accommodative despite the upside risks to the inflation target of 5.0% by March 2017.Monetary policy setting in India is set to enter a new era, with a new Governor as well as the shift towards a Monetary Policy Committee (MPC)-determined policy rate. Amidst these substantive changes, the Government of India’s (GoI’s) decision to retain the CPI inflation target at 4+/-2% up to March 2021, would impart stability to policy setting. ICRA expects the RBI to leave the repo rate unchanged in the October 2016 Policy Review as it awaits additional data, and defer a 25 basis points (bps) rate cut to the December 2016 review meeting, in spite of the lag in transmission of policy easing to bank lending rates. The CPI Inflation is likely to track a U-shaped trend in the remainder of this fiscal, with continued volatility in monthly readings, albeit within the 2-6% inflation tolerance band. Benefitting from a moderation in food inflation, the CPI inflation is likely to print in the range of 4.0%-5.0% in the remainder of CY2016. As the favourable base effect fades and domestic demand revives, a gradual up-trend in retail inflation is likely between December 2016 and March 2017, with the RBI’s interim target of containing the CPI inflation at 5.0% in March 2017 being narrowly missed.Despite a weaker-than-forecast volume of monsoon rainfall, surplus rains in July 2016 supported a healthy increase in kharif sowing. The recently released First Advance Estimates of crop production predict a substantial increase in output of most kharif crops, barring sugarcane. In particular, as against a 6% rise in coverage of food grains and oilseeds, the Advance Estimates forecast a healthier 13% rise in their output, which would ease inflationary pressures. However, sugar prices are likely to remain firm for the next year, given the subdued domestic production for sugar year 2016 (October 2015-September 2016) and the bleak outlook for sugar year 2017 (October 2016-September 2017).  The anticipated moderation in average CPI inflation to ~4.6% in H2 FY2017 from ~5.5% in H1 FY2017, partly benefitting from a favourable base effect as well as the record kharif harvest predicted by the First Advance Estimates for crop production, suggests that there is room for another 25 bps rate cut in 2016. However, the Monetary Policy Committee may choose to wait for confirmation of the dampening effects of the higher output on prices after the harvest reaches the market, before embarking on the rate cut. Moreover, core-CPI inflation rose to 4.7% in August 2016 from 4.6% in July 2016, suggesting that it may be prudent to observe the impact of the revival in domestic demand subsequent to the pay revision, even though moderate capacity utilisation in many sectors would buffer inflationary pressures. With the Q1 FY2017 economic expansion in line with our forecast and the expected uptrend in agricultural output despite the lower-than-predicted monsoon rainfall, ICRA continues to expect a consumption-driven pickup in GVA growth to 7.7% in FY2017 from 7.2% in FY2016. Nevertheless, growth would remain uneven across sectors, with a patchy performance of private sector investment activity, particularly given moderate capacity utilisation levels, and a mixed recovery in infrastructure.Bond yields have corrected further in the ongoing quarter, partly on account of improved liquidity conditions. While the transmission of past monetary easing by the banking system would remain an area of focus, ICRA expects the pass-through to be constrained by subdued profitability of the PSU banks. With a re-emergence of the seasonal tightness in systemic liquidity, ICRA expects additional open market purchases of Government securities of Rs. 500-600 billion in Q3 FY2017, as the Central Bank remains committed to reducing the structural liquidity deficit.Author is senior economist at ICRA