Sharp fall in inflation strengthens case for RBI to ease rates again

Market expectations for a policy interest-rate cut have increased, and several entities are reported to have postponed their fundraising plans in anticipation. Reserve Bank of India (RBI) Governor Sanjay Malhotra, in his remarks this week, has noted that the possibility of rate cuts, as indicated in the October meeting of the Monetary Policy Committee (MPC), remains intact. However, he also underlined that whether the committee decides to act in the upcoming meeting would depend on its assessment at that time. The next MPC meeting is scheduled for December 3-5. Inflation outcomes are also fuelling market expectations. The consumer price index-based inflation rate declined to 0.25 per cent in October, as against 1.4 per cent in the previous month, and is running significantly below the central bank’s target of 4 per cent.

 

The MPC reduced the policy repo rate by 100 basis points this year, and its decision in the December meeting will depend largely on how it expects the inflation rate to evolve in the coming quarters. It is worth noting that the decline in the inflation rate has been driven largely by food prices. The core inflation rate (non-food, non-oil) is running around 4 per cent. The food-price inflation rate declined to (-) 5.02 per cent and has been falling consistently over the past year. The food-price inflation rate in October last year was over 10 per cent. Thus, essentially, it’s the expectation of food prices that would play a major role in the MPC’s decision. Given the favourable monsoon and reservoir levels, it is reasonable to assume that food prices will remain supportive in the coming months, though to what extent this will change the headline inflation projection will be worth watching. In the October policy, the MPC expected the inflation rate to average 4 per cent in the last quarter this financial year and 4.5 per cent in the first quarter next financial year. These projections will have to change favourably, which is a possibility, to enable the MPC to further reduce the policy repo rate.

 

However, to what extent a 25 basis-point rate cut will help boost growth would be difficult to determine. The second-quarter gross domestic product (GDP) numbers are due later this week. In the first quarter, growth at 7.8 per cent surprised most forecasters, including the RBI. A similar outcome in the second quarter could reduce the marginal impact of a potential rate cut. It is being reported that the reduction in goods and services tax rates has given a big boost to consumption. However, it will be worth watching if the momentum sustains for a reasonable period. From the growth perspective, the conclusion of the trade deal with the United States will be more crucial than a policy rate cut. Trade negotiations with Canada have also been resumed. Its early conclusion will support growth.

 

A possible rate cut could affect foreign debt-capital flows. There are concerns about the rupee’s depreciation. However, given the near-term comfort on the inflation front, this should not worry policymakers, and the rupee should be allowed to depreciate. Although it cannot fully offset the American tariff disadvantage, a favourable currency will help exporters in other markets and, to some extent, compensate for the loss of the US market. In sum, the recent inflation outcomes will provide strong reasons for the MPC to reduce the policy repo rate. But monetary policy needs to be forward-looking. Thus, the key will be how the projections change.