Muted expectations of rate cuts on RBI’s 4% inflation target could lead to banks keeping lending rates at higher levels, government bond yields staying flat or trending up and overall economic sentiment not getting a strong boost leading to weaker than expected economic growth. If this happens, government may go back on fiscal reforms leading to rising inflation expectations. Back to square one situation for markets and policy makers.
The Monetary Policy Framework Agreement signed by the Government and the Central Bank in February 2015 guides RBI policy. The inflation target for RBI is CPI inflation at 4% with +/- 2% leeway beyond which the central bank has to give an explanation to the government on why inflation has overshot or undershot levels. Monetary policy is now officially an inflation targeting policy. Watch our Two Minutes Concept Series Video on Inflation Targeting.
CPI inflation for March 2015 printed at 5.17% against February levels of 5.37% and March 2014 levels of 8.25%. CPI food inflation was 6.14% against 6.88% and 8.64% respectively. CPI is expected to go down to 4% over the next few months before climbing up to over 5% levels be January 2016. RBI’s target for CPI as of January 2016 is 6%.
RBI has set itself an ambitious target of CPI inflation at 4% by end of 2017-18. Hence over the next three years, CPI inflation is expected to trend down to 4% levels and stay there. Given that CPI inflation had averaged 9.5% over the five year period until 2013-14, the average consumer will look at RBI’s target in disbelief. Inflation has only trended down over the last two years and that is largely aided by high base effect and global oil and commodity prices falling sharply. Oil prices are down 50% over the last one year while commodity indices are down over 25%.
RBI has many variables that it cannot control. Government is a big question mark and commitment to reforms may vanish if there is no political consensus. Government’s target of 3% of GDP by 2017-18, if achieved, will have a huge positive effect on lowering inflation but the question is will the government achieve its target if economic growth and taxes do not deliver to expectations?
Food prices have been extremely volatile over the last few years due to factors such as weather, hoarding, transport costs etc. One poor monsoon or few unseasonal rains or other weather disruptions can cause food prices to shoot up leading to sharp rise in CPI inflation that has a weight of 46% in the index. RBI has not specified non food inflation as its target and hence general index levels will determine policy.
Global commodity cycle is down at present and is expected to stay down for a while given various factors including US shale oil revolution and China growth slowdown. However commodity cycle can change going forward as markets readjust to new demand and supply conditions. Once the cycle turns, inflation expectations will tend to rise.
The bigger question for markets at present is, if RBI is targeting 4% CPI by end of fiscal 2017-18, will it keep policy more neutral than accommodative? That would mean rate cuts tapering off by the end of this fiscal year. RBI has cut rates by 50bps since January 2015 and expectations are that further rate cuts if any would be a total of 50bps. This is assuming that CPI inflation stays at 5% levels by end of this fiscal year.
Economic data shows small signs of improvement but challenges remain.
IIP (Index of Industrial Production) growth for the April 2014- February 2015 period was just 2.8% against a negative growth of 0.1% seen last year. Manufacturing growth was 2.2% against negative growth of 0.7%. Capital goods growth was 6% against -2.6% while consumer durables growth was negative 13.3% against negative 12.3%.
Bank credit growth has slowed down considerably since last year. Bank credit grew by 9.52% year on year as of March 2015 against a growth of around 14% seen in March 2014. Slowing bank credit substantiates weak IIP data.
Trade data shows that exports grew by 0.88% in the April 2014– February 2015 period while imports grew by just 0.71% with non oil imports growing by 8.14% largely due to 132% jump in gold imports. Anemic growth in exports and imports suggest weak external and domestic demand.