Should the RBI review its policy outlook?

The RBI in its April policy had surprised us by scaling up the inflation trajectory by 25 bps, with 1HFY18 averaging 4.5%. But it appears that inflation may be substantially lower by ~130 bps than its projection, with the next few prints likely to be sub 3%. Even as we expect the inflation trajectory to inch towards 4.5% mark by March 2018, the 2HFY18 average will still remain much lower than the RBI’s estimate of 5%.
 
Further, core inflation (ex-petrol and diesel) has been trending downwards over the past six months depicting continuing growth slack. Finally, GST rates will likely lead to ~20 bps fall in CPI inflation (assuming smooth implementation and efficient input tax mechanism) with most goods’ rates broadly unchanged and in some cases lower and only a few services will see some uptick.

 
The upside inflation risks RBI noted in the April policy have continued to fade: (1) Crude prices have stabilized at current levels with limited meaningful near-term upside threat, (2) imported inflation risks out of FX depreciation have dissipated and on the contrary INR strength will add to the disinflationary forces. We do not see INR depreciating sharply enough through the year to impact inflation meaningfully and (3) global reflation theme is losing momentum with subsiding global volatility, with markets seeing lesser risk of upside surprise by global central banks.
 

We see a few adverse domestic risks to inflation over the next one year. (1) While 7CPC-related HRA announcement is pending, we estimate 60 bps direct increase (statistical) assuming implementation from July. While RBI may choose to ignore the statistical effect, it will need to act (per RBI Act) in case inflation remains above the 6% mark for more than three quarters. (2) GST regime could take time to streamline. The transition period could see some pricing distortions as firms gain clarity on inventory management, input tax credit mechanism, and as increased compliance pushes informal sector’s production cost. (3) A disappointing monsoon (IMD forecasts a normal monsoon) could pressurize fruits, vegetables and pulses prices, implying need for continued effective food price management by the government.

 
We believe that an inflation-targeting central bank should be conservative and cautious in its estimates and views. Since the December policy, RBI has been turning more cautious by each meeting on inflation fears. However, we note that RBI has missed its inflation estimates consistently over the past few years.
 
Over the longer term, significant deviation between estimates and actual outturn could risk a negative effect on expectation settings in an inflation-targeting framework. Thus ideally we would expect the RBI to review its communication in the June policy to acknowledge the significant downward bias to its estimates. Even as we expect RBI’s tone to soften, we continue with our call of an extended pause as the 2HFY18 headline inflation is likely to still remain higher than the medium-term target of 4%.

 
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The article has been excerpted from a Kotak report co-authored by Suvodeep Rakshit, Madhavi Arora and Upasna Bhardwaj.