Has RBI jumped the Gun (Quick Gun RBI is Borrowed from the Comedy Movie Quick Gun Murugan) in turning policy from accommodative to neutral in its 8th February 2017 policy review? Many market participants believe that RBI’s decision has been hasty especially since the pain of demonetization has still not eased and the fact that the Union Budget 2017-18 has not been inflationary. RBI has lowered inflation forecast for March 2017 to well below 5% levels from 5% levels earlier and growth forecast for fiscal 2016-17 from 7.4% to 6.9% levels. Government has lowered its fiscal deficit target for fiscal 2017-18 to 3.2% of GDP from 3.5% of GDP seen in fiscal 2016-17 despite demonetization pains.
RBI has not been really worried about inflation for fiscal 2017-18 with CPI inflation forecast of 4.5% to 5% while it has been optimistic on growth projected at 7.4%. The repo rate at 6.25% is in line with RBI real rate of interest target of around 1.25%. So why the change in stance and will this hurt the economy going forward? Will RBI have to turn accommodative later down the line?
RBI policy change in stance from accommodative to neutral stems from the belief that upside risks to inflation in fiscal 2017-18 are higher as compared to fiscal 2016-17. The reasons include, improved economic prospects globally especially in the US as President Trump focuses on economic growth, rising global commodity prices that have climbed from lows seen in 2016 and India getting back on the growth track as economic environment turns favourable globally and domestic demand rising on the back of low interest rates and high liquidity conditions prevailing in the economy.
Core CPI inflation has stayed sticky at around 5% levels despite CPI inflation coming off to 3.17% in January 2017 while WPI inflation climbed to 5.25% in January 2017, widening the spread with CPI. Read our note on Widening CPI-WPI spread. Rising aggregate demand would lower the output gap and that could lead to core inflation rising and taking up inflation expectations.
Interest rates are down sharply by over 300bps over the last few years and with banks being flushed with liquidity on demonetization, RBI expects pick up in consumer demand. Investment demand has lagged due to twin balance sheet issues of bank NPA’s and corporate leverage and no new capacities have been created for a while. Hence rise in consumer demand could lead to pressure on supply that would lead to higher prices.
Globally, economic data across US and Eurozone has shown improvement and that is leading the Fed to hike rates and other central banks to start turning neutral on policy. Read our Global Economic Data Analysis – 3% on 10 year UST is not far away.
India’s exports too have shown growth of 4.34% in December 2016, the 5th consecutive month of rise in exports while imports grew 10% led by 61% rise in oil imports as oil prices have doubled from lows seen in 2016. Higher exports is a positive sign for global demand while rising oil prices leads to higher fuel prices, which is inflationary.
It is unlikely that RBI will change its policy stance again unless global economy shows signs of weakening rather than strengthening.