RBI PREVIEW: Time to shift focus to growth than inflation
The monetary policy committee (MPC) of India’s Reserve Bank of India (RBI) will conclude its two-day meeting tomorrow and announce its decision at 1430 IST. Almost unanimously, the market expects the MPC to hold rates tomorrow. We, however, are an outlier, who argues that RBI has sufficient room to cut rates tomorrow and must act on it. There are three key arguments for the same (We had discussed our argument in a note released almost three weeks ago).
1.) Almost entire jump in headline CPI is due to volatile/one-off items. Excluding them, inflation is at record-low of 2.7% in August 2017
Headline CPI-inflation has more than doubled from its 15-year low of 1.46% YoY in June 2017 to 3.36% in August 2017; however, as we have discussed in our note, about 70% of the higher inflation in the past two months was on account of ‘vegetables’, which are neither influenced by monetary policy, nor it should affect monetary policy. Further, with weight of ~6% in total CPI and its highly volatile nature, ‘vegetables’ was rightly looked through by the monetary policy in the past and should be continued now also. Excluding ‘vegetables’, retail inflation was 3.1% YoY in August, only marginally higher than low of 2.9% in June 2017.
Further, another volatile item called ‘fuel for vehicles’ (weight 2.4%), which is subsumed under ‘transportation & communication’ and thus, gets included into core inflation grew 10% YoY last month. Finally, ‘housing’ (Weight 10.1%) also witnessed a small expected uptick on account of statistical effect, due to the revision in house rent allowances (HRA) by the central government. Together, these three items - vegetables, fuel and housing, which have an aggregate weight of ~20% account for the entire jump in headline CPI in the past two months. Excluding these three items, retail inflation was 2.7% in August 2017, same as in June 2017. In other words, 80% of the CPI basket is witnessing record-low inflation.
2.) With inflation remaining tamed, time to shift focus to growth
Whether inflation is 3% or 3.5%, or whether it is expected to increase to 4.5% or 5% by March 2018, irrespective of all this number jugglery, it is almost unanimously held that CPI-inflation will likely average 3.5% for the entire FY18, lower than 4.5% in FY17. In this uncertain economic/political environment, it may not be worth discussing FY19 now and being too forward-looking. Rather than fearing the future, it may be suggested to do the best to bring your present in shape. While higher inflation in future is a perennial fear (among the markets and the policy makers), the growth slowdown is a reality. All skepticals questioning the credibility of GDP data has suddenly gone on mute mode, as the slowdown in evident. Our monthly economic activity index (EAI), which shares very high correlation with official GDP (excluding discrepancies) statistics and helped us identify the inflection point accurately in 4QFY17, indicates that GDP growth ~6% for the third consecutive quarter in 2QFY18. Neither July no August have shown any signs of strong uptick in 2QFY18. If so, we believe that the MPC should start focusing on growth rather than inflation, which is expected to remain tamed for at least a few quarters.
3.) With no/limited fiscal room, monetary policy must support economic growth
Moreover, while the economic slowdown in real, we don’t believe that India needs a fiscal stimulus. There are two simple (and one complex) arguments for this. Firstly, the quality of fiscal stimulus is highly inflationary in India, which will sooner or later negate the effects of higher growth. Secondly, even without a stimulus, the credibility of fiscal target of 3.2% of GDP is highly questionable (fiscal deficit has touched 96% in the first five months of FY18). As far as the complex argument goes, we have already argued (and will reiterate soon) that all fiscal stimulus are not necessarily growth-enhancer. What matters is the financing of higher deficit. If higher deficit is financed by foreign savings (or leads to higher CAD) or the monetary authority (RBI, in this case), then the fiscal stimulus will boost growth. However, since domestic savings are most likely to finance higher deficit. Thus, fiscal stimulus, if happens, will not enhance growth. In such a time, the monetary authority, we believe, must exercise all the room it has to cut policy rates.
Finally, we also want to debate with the section of people who would point to weakening currency as an argument against further rate easing. INR has weakened from 63.90 against US Dollar almost a month ago to above 65.50 today. Does it reflect India’s fundamentals, global economic environment or something else? We believe it has more to do with the rising geopolitical tensions between North Korea and the US, which is leading to weaker INR against USD. This is not a coincident that almost all emerging market currencies have weekend against USD in the past month, with South African Rand weakening by as much as 5% and Indonesian Rupiah by 1.7%. INR has weakened by ~2.5%, lying in the middle. USD, on the other hand, has strengthened ~3% to its highest level since mid-July now. All-in-all, we don’t believe that rate cut would deteriorate the INR prospects. Theoretically, if lower rates could deter foreign investors, the prospects of better growth due to policymakers’ support could also instill confidence among foreign investors and practically, emerging market currencies are more a function of global economic/political environment than domestic fundamentals.
Overall, we believe that the MPC has sufficient room to cut rates tomorrow. While the jump in headline inflation by 2 percentage points in two months may sound/seem too much, a little scratching over the surface will make the concern look highly shallow. If the newly-formed MPC wants to establish credibility, they will help themselves by sticking with the reality rather than marrying any pre-conceived notion.