The Reserve Bank of India’s (RBI) macroeconomic narrative for fiscal 2018 suggests it sees a downside to both growth and inflation projected earlier. The gross value added (GVA) prognosis has been lowered 10 basis points from the previous estimate of 7.4%. One basis point is one-hundredth of a percentage point. Not so surprisingly, RBI cut the inflation forecast for the second half of this fiscal sharply to 3.5-4.5% from 5% earlier.
So macroeconomic undercurrents have softened Mint Road’s tonality, not the rate.
In its February 2017 review of the monetary policy, the RBI had sprung a surprise by shifting its stance from accommodative to neutral, which afforded it the flexibility to move cyclically or counter-cyclically. Undershooting inflation, if perceived as durable, would veer intent towards a rate cut. But the RBI does not believe a rate cut is warranted now, saying, “premature action at this stage risks disruptive policy reversals later and the loss of credibility.” That said, easy liquidity conditions have de facto softened rates, even without a formal lowering of the repo rate. Additionally, lower risk weightage for housing loans will help support demand for homes. But what undershooting inflation does for sure is rule out a rate hike in the foreseeable future, so the RBI’s stance would, in effect, be accommodative than neutral for now.
Which brings us to the question: where are growth and inflation headed?
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Data released on 31 May confirmed the adverse impact of demonetization on gross domestic product (GDP) growth. True, growth was already slowing, having fallen to 7.5% in the second quarter of last fiscal from 7.9% in the first. That added up to overall growth of 7.7% in the first half.
The second half was supposed to be better, benefiting from another good monsoon and the Pay Commission-led boost to consumption. True, agricultural and government consumption growth improved to 6% and 26.4%, respectively, in the second half from 3.3% and 16.5% in the first. Yet, overall GDP growth slowed to 6.5% in the second half as adverse effects of demonetization kicked in.
While the slowdown largely seems to be a two-quarter phenomenon and a re-monetized economy should start grinding up in the first quarter of the current fiscal, some adverse effects of demonetisation could linger. Which is perhaps why the RBI would wait before wielding the knife.
Given all this, and in an environment of subdued global growth and weak investments, India cannot grow faster for now. And likely disruptions emanating from the implementation of the goods and services tax (GST) will add to the challenges.
These are the reasons why we at Crisil maintain our outlook of 7.4% GDP growth this fiscal, or 30 basis points rise from last fiscal. The improvement is also predicated on a rebound in consumption demand, which was postponed by demonetization, another spell of normal monsoon, and somewhat softer interest rates.
Inflation trends are always a difficult call. Assessing whether a decline or spike is transitory or durable challenges Indian policy makers because a large part of it is driven by food prices on which they do not have a firm grip. And then there is the ever-present risk of higher commodity and crude prices to countenance, too.
In July 2016, inflation had crossed the lakshman rekha of 6% as food prices spiked. That was seen as transitory and we did see a repo rate cut when inflation retracted.
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The situation is quite the opposite this fiscal. The high-base effect of May-August 2016 will keep inflation statistically low till July-August this year. After that, inflation is expected to move up. We expect CPI inflation to average 4% in fiscal 2018 given the prospects of normal rains, modest uptick to commodity prices and a stronger rupee.
While RBI now expects a sharp decline in inflation, it does not rule out risks to the revised inflation outlook. RBI, therefore, preferred a pause than risk a policy flip flop.
While private consumption growth remains healthy (the Central Statistics Office estimates it at 8.7% in fiscal 2017), it’s not enough to stir weak private investments, which are seen as a drag on the economy.
Coming back to rate cuts, can they offset the headwinds and revive private investments?
Indeed, interest rates play a small role in reviving private investments. Crisil’s 2014 study (Will a rate cut spur investments? Not really) showed investments have slowed even in times of low interest rates. What matters more is the business environment or the expected return on investments. These, in an environment of low capacity utilization and weak balance sheet of companies, continue to be deterrents. To be sure, lower rates do reduce the interest cost for corporates and support consumer demand in rate-sensitive sectors.
Given its aggressive inflation glide-path target of 4%, the RBI has bet caution now would deliver better dividends later. The door for a rate cut in August is still open.
Dharmakirti Joshi is chief economist, Crisil Ltd.