Upside Risks to Inflation Leaves Little Headroom for RBI to Cut Policy Rates in Near Term

India Ratings and Research (Ind-Ra) believes maintaining of status quo by the Reserve Bank of India (RBI) on the policy rates at this juncture is the correct stance, keeping in view the upside risks to inflation. Also, Ind-Ra believes institutionalising the process of policy rate setting through the formation of a monetary policy committee and formalisation of the existing 4% (plus/minus 2%) inflation target (over FY16-FY21) will leave little headroom for RBI to cut the policy rates in the near term. This is because RBI targets to bring down retail inflation to 5% by end-FY17 and 4% by end-FY18.

RBI in its third bi-monthly review for this fiscal maintained status quo on the repo rate. The repo rate, reverse repo rate, and marginal standing facility rate continue to stand at 6.5%, 6.0% and 7.0%, respectively. RBI also kept the cash reserve ratio unchanged at 4% in line with Ind-Ra's expectations. The central bank maintained that the risks to the inflation target of 5% for March 2017 remain on the upside.

RBI's assessment is guided by the trajectory inflation may take in the near term, given the stickiness in food and services inflation. The Consumer Price Index (CPI) number for June 2016, which was the highest in 22 months at 5.8%, lends support to the central bank's concerns about the upside pressure on inflation. Food inflation was the main driver of the headline CPI in June 2016, with the rise in vegetable prices being higher than occasioned by seasonal factors. According to RBI, the price rise in vegetables, sugar, cereals and pulses has fed through into households' expectations of inflation in the near term, which is a reversal of the decline observed in 1Q and 2Q of 2016. The implementation of the 7th Central Pay Commission award is likely to directly impact house rents, which is a component of CPI.The impact of house rent allowances on inflation expectations will need careful monitoring by the central bank to pre-empt a generalisation of inflation pressures.

The central bank noted three key positive developments on the domestic front, (i) kharif sowing has gathered pace after a lacklustre start, particularly with respect to pulses (ii) there is some improvement in business confidence and (iii) liquidity conditions have eased and yields on government bonds have dropped.

The central bank expects the favourable monsoon seen so far to alleviate some pressure on food inflation in the near term while fuel prices might stay benign. However, the trajectory of inflation, excluding food and fuel prices, looks uncertain as even if food and fuel prices do not exert upside pressure on prices, the pressure may arise from the shrinking output gap.

According to RBI, growth momentum is expected to pick-up pace, led by agricultural growth and rural demand, aided by a normal monsoon. Consumer spending is likely to get a boost from the disbursement of pay, pension and arrears following implementation of the 7th pay commission award. The central bank's forward-looking surveys indicate a continuing improvement in business confidence and a pick-up in new orders; however, investment demand remains weak as evidenced by the prolonged sluggishness in capital goods output.

The central bank has retained its projection of gross valued added growth for FY17 at 7.6% based on its assessment of risks from domestic and global factors. Aggregate demand conditions in the economy are likely to benefit from the current accommodative monetary policy stance of the central bank. However, comfortable liquidity conditions, slower economic growth in advanced economies, downgrades of global growth projections, and continuing sluggishness in world trade could play spoilsport so far as external demand is concerned. The increased volatility in global financial markets post Brexit, has prompted investors to look for safe havens driving yields even further into negative territory.

Despite the limited manoeuvrability to change policy rates, the agency believes sentiment in the bond market will stay positive on account of RBI's endeavour to bring core systemic liquidity close to neutrality. Out of net G-sec supply of INR1.6trn (till July 2016) in FY17, RBI's Open Market Operation purchase has neutralised this supply by INR805bn. Liquidity will be the main driver for the bond market, enabling favourable demand-supply dynamics. Additionally, Ind-Ra expects a high interest rate differential, amid narrowing inflation rate differential, and a stable currency to augur well for the domestic debt market.

RBI yet again emphasised that the challenges arising out of the redemption of foreign currency non-resident (FCNR B) deposits will be manageable. In the post policy conference, the RBI governor highlighted that around 80% of the upcoming maturities have been covered in the forward market while access to nearly USD365bn foreign exchange reserves remains. The agency believes that with risks arising out of FCNR B deposits being manageable, rupee is poised to trade with a positive bias. Also, India will remain on the radar of the global investors with major global central banks staying on the accommodative mode and Goods & Services Tax Bill finally passed by the Parliament. In July 2016, net portfolio flows in equity segment have been USD1.7bn while debt flows totalled USD859m. Overall, the agency believes relative resilience of rupee will continue over the upcoming months.

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