Rates on hold, RBI sharply cuts inflation forecasts

The Reserve Bank of India policy committee kept benchmark rates on hold on Wednesday, but cut inflation forecasts sharply. Marking a first, the decision was not unanimous, with a 5-1 vote. The SLR (Statutory Liquidity Ratio) was cut by 50bps to 20 percent, which will free up funds for lending purposes and provide banks with better flexibility to meet the higher LCR (Liquidity Coverage Ratio) that kicks into effect in January18.

Back to policy, the April CPI inflation had already set the stage for a large miss of RBI's earlier projected path. Official inflation estimates were slashed yesterday, with 1HFY18 (Apr-Sep) inflation now seen at 2.0-3.5 percent and 2H at 3.5-4.5 percent.

This mark a revision from 4.5-5 percent estimated earlier. While the guidance softened vs April, there was little to suggest that they have turned outright dovish. Emphasis was on gaining more clarity towards a) whether Apr's weak momentum can sustain, b) softer core inflation might prove short-lived in midst of better rural wages and firm consumption, c) impact of the seventh pay commission needs to be worked into the calculations, and d) flagged fiscal risks for states from loan waivers. They also remain concerned that a rate cut might not materially buoy investment growth, but raise credibility issues if it leads to a reversal (to hikes) next year.

The growth forecast for FY18 was lowered by a moderate 10bp to 7.3 percent, while assuring that lower lending rates, government spending and remonetisation will underpin recovery this year.

At this juncture, inflationary risks are subdued. Imported pressures are benign, given a strong rupee and stable oil prices. Bulk of the inflation basket have been exempted from GST, with tax incidence likely to rise on the service sector components. The seasonal spurt in food prices, that usually plays out in 2Q, looks subdued this year thanks to a combination of ample supplies, a good harvest and support from administrative measures.

Monsoon progress is also encouraging, with actual rainfall trending at 5 percent above normal by 5 June. Growth is still below trend, pointing to a negative output gap. Taking a forward-looking approach however, inflation is likely to drift up in second half, as growth stabilises from 1Q trough and disinflationary forces subside.

In all, the above factors are likely to keep inflation close to the RBI's revised path. By Aug's review, the committee will be armed with May and June inflation numbers. Given the balanced tone yesterday and reluctance to ease rates, we maintain our on-hold call on policy. But acknowledge that odds of a rate cut in August is rising.

The deciding factor, in our view, will be i) May inflation slips below 2.5 percent, and/ ii) if June inflation breaks below their projected path; in essence testing the lower bound of the targeted 2-6 percent range. The minutes due on June 21 will be watched for any guidance shift amongst the individual members, especially the one who dissented on Wednesday.

The author is economist, group research at DBS Bank, Singapore; views expressed are personal.