Economic and financial conditions increase chance of a repo rate cut

The full Monetary Policy Committee will reportedly meet to decide actions at the next bi-monthly review. Current and expected economic and financial conditions suggest that there is a better than even chance of a repo rate cut. 

Financial conditions have eased significantly since the change in RBI’s liquidity framework from April 2016 with the benchmark overnight call rates staying within a narrow band of the repo rate. Current indications are that foreign currency inflows are likely to help support system liquidity. The US Fed’s hold decision, together with a more dovish tone, and a conservative slant to the major central banks’ policy positions augurs a period of relative stability for financial markets. This will help smooth India’s FCNR redemption process. Consequently, the Rupee is likely to remain stable in the near term, with near term forward rates also having fallen. 
 

The growth – inflation tradeoff still remains consistent with an easing stance. Growth remains weak, although aggregate demand is likely to gradually improve, originating in the good monsoon fed agriculture sector and diffusing into the rural services ecosystem. Capex will depend largely on public spending, but indications are that recovery will be very gradual. 

The decision to cut the repo rate will hinge dominantly upon the view on inflation. Over the next few months, CPI inflation is likely to drop, (to less than 4.5% in November 2016), and meet RBI’s forecast of 5% by March ’17, under some reasonable assumptions.  However, are there now structural trends consistent with a longer term alignment of inflation with the 4% target? It appears that the average CPI inflation in FY18, one year from now, will be around 4.3%. But there are risks to this view. Inflation expectations still remain fairly sticky. If we add the effects of the 7th Pay Commission recommended HRA increases, the initial effects of a reasonable GST standard rate, the progressive diffusion of the salary increases to state Government employees and a slight rise in crude and commodities prices, we might see a 0.6 – 1.0% increase in the inflation rate over the base. However, some of this is likely to be a one-off rise, amenable to a see-through. Capacity utilization remains low, inhibiting pricing power. 
 

By RBI’s own metric, the neutral (interest) rate is the real one year ahead T-bill rate  at around 1.5 – 2.0%, which given historical spreads, translates to a 1.0 – 1.5% real repo rate. The expected growth and inflation trajectories over the next few months might open up room for RBI room to gradually cut the repo rate to around 6%. 

The author is Chief Economist at Axis Bank