Changing, but cautious

The December monetary policy review will be all about communicating the Reserve Bank of India (RBI)'s response function to an unexpected sharp drop in inflation. Consumer Price Index-based inflation has fallen to 5.5 per cent in October, a drop of about 465 bps in one year. Almost 70 per cent of this drop is explained by falling food prices and another 15 per cent by fuel prices.

Falling inflation has raised the clamour for monetary easing. In the June policy review, RBI had mentioned that if towards the end of the year, inflation falls more than what the base effect suggests, then it could open up some space for monetary easing. So, from that perspective it will be fair to expect RBI will indicate an easier policy going forward, even if it refrains from reducing rates in December.

However, we think there could still be a cautious undertone to the RBI statement. Most of the fall in inflation has been just a reflection of global commodity prices. The RBI might want this decline in inflation to translate into lower inflation expectations.

Also, it is too early to say whether the supply-side bottlenecks, which kept inflation elevated for so long, have been properly addressed or not. Without these reforms, particularly in the food economy, inflation could again inch up if global commodity prices rebound in 2015. A premature rate cut could impact the credibility of the rather new inflation targeting framework, even if there is a mild increase in inflation after the rate cut.

If the central bank is patient about the first rate cut and lets the disinflationary forces to get well-entrenched then there could be deeper rate cuts in the future. For that real interest rates need to stay higher for a bit longer. It's important to acknowledge the drop in inflation but it is too early to uncork the bubbly.

The author is head of Research, India at Standard Chartered Bank India