Low inflation may ensure an easy money regime

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Mumbai: Rarely does a central bank feel happy when its prediction goes wrong, but the latest release of wholesale price inflation data, on 15 April, was such an occasion for the Reserve Bank of India (RBI). The data showed that the genie of wholesale inflation had finally been bottled in India, Asia’s third largest economy, and it may remain so at least for the time being with global commodity prices increasingly moving south.
Wholesale price inflation dropped to a 40-month low of 5.96% in March, from 6.84% in February, much below the most optimistic market estimates. It is also lower than RBI’s year-end inflation projection of 6.8%.
Indeed, the fiscal year that ended on 31 March was a volatile one, and RBI changed its year-end inflation estimate thrice after estimating it at 6.5% in April 2012. Subsequently, it raised the estimate to 7% in July, and 7.5% in October, before lowering it to 6.8% in January. The final figure, which surprised all analysts, is lower than all RBI estimates.
Governor D. Subbarao should feel happy because it creates space for monetary easing, the lack of which he had rued in the central bank’s mid-quarter policy review statement in March, fuelling widespread apprehensions about the future of the interest rate trajectory in a slowing economy where close to 450 projects, both old and new, involving Rs.10.5 trillion of investment, have been stalled.
The higher cost of money is one of many reasons for spoiling the investment climate.
The good news doesn’t end with the drop in wholesale inflation. The non-food, non-oil, manufacturing inflation, or the so-called core inflation, which RBI watches closely, is also continuing its southward movement. In March, it dropped to 3.48%, much below most market estimates, and its lowest since February 2010. With this, the average core inflation rate in the year ended March stood at 4.84% and average wholesale inflation at 7.35%, both at their lowest levels since fiscal 2010, a year after the world witnessed an unprecedented credit crisis following the collapse of US investment bank Lehman Brothers Holdings Inc. In March 2010, the Indian central bank took the first step to raise its policy rate after it had been reduced to a historic low.
There could, however, be minor changes in the figures because the February and March inflation data is provisional and the final figures could be higher. For instance, the January wholesale price inflation was revised up from 6.62% to 7.31%.
Commodity price meltdown
Both primary food inflation and manufactured products inflation dropped sharply, contributing to the lower number in March, and inflation risks may continue to retreat with a meltdown in global commodity prices and a slowing Chinese economy. Gold and silver prices have seen a sharp correction in the past few weeks and the US crude oil price dropped to about $100 a barrel, around 15% lower than in March, when RBI cut its policy rate by a quarter of a percentage point to 7.5% but virtually ruled out aggressive rate cuts in the future, saying the scope for further monetary easing was limited.
Relatively low wholesale inflation and an even lower inflation outlook strengthen the belief that a rate cut would be announced in May. There are other reasons as well. Both the HSBC Manufacturing Purchasing Managers’ Index and Services Purchasing Managers’ Index dropped in March to 52 and 51.4, respectively, the lowest in about one-and-a-half years. The two are economic indicators derived from monthly surveys of private sector companies; an index reading above 50 signifies expansion and below 50 suggests a decline. In relative terms, they declined the most since October-November 2011.
Overall, growth indicators remain considerably weak despite a 0.6% rise in factory output in February (against analysts’ estimates of a 1.5% contraction). The upside surprise was the result of a bounce in capital goods production, the first in four months, but it certainly doesn’t call for celebration. The average factory output growth in the first 10 months of the fiscal—between April and February—was 0.9%, the lowest since 2009.
Economic growth in India slowed to 4.5% in the December quarter, the lowest in a decade, and nobody expects it to clock more than 5% growth for the year.
Car sales shrank in the fiscal year for the first time in a decade and air passenger traffic fell for the 10th consecutive month in February.
This background suggests that the stage is set for a rate cut on 3 May when RBI announces its annual monetary policy; but the question is: Will Subbarao stick to his “baby step” of a 25-basis points (bps) cut or show boldness by combining it with a cut in the banks’ cash reserve ratio (CRR)—the portion of deposits that commercial banks need to keep with RBI—by an identical margin? Some bond dealers have even started punting on a 50 bps policy rate cut. One basis point is one-hundredth of a percentage point.
CRR is now 4% and the repo rate, or the rate at which RBI lends to funds-starved banks, is 7.5%. The repo rate is the policy rate when the system runs in a cash deficit mode.
RBI had started paring rates in the wake of the Lehman Brothers’ collapse, in October 2008, and brought it down to 3.25%, the lowest in the Indian central bank’s history, by April 2009. Then, after 13 hikes, the policy rate rose to 8.5%, its recent peak, in October 2011. The first rate cut happened in April 2012, a 50 bps reduction, and it was followed by two cuts of 25 bps each in January and March.
RBI may find it difficult to go for a sharp rate cut for two reasons. First, retail inflation remains high, in double digits. In March, the consumer price inflation, or retail inflation, dropped to 10.4% from 10.9% in February, against street expectations of 10.7%; but it’s still high.
A reduction in fuel subsidies may continue to contribute to retail inflation. Second, a record high current account deficit (it could be around 5.1% for fiscal 2012) is yet another factor that will weigh against a substantial rate cut.
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A section of analysts believes that the high current account deficit could spike any rate cut, but this is unlikely as the deficit is not the result of an over-heated economy, but a near-collapse of the export market. Indeed, India needs inflows of foreign funds and, theoretically, a lower interest rate regime discourages such inflows. But the nation does not have full capital account convertibility and the flow of foreign funds is not unlimited—the flow into the debt market is capped at $25 billion for government bonds and $50 billion for corporate bonds. So lower interest rates will not deal a blow to foreign fund flows. Besides, the sharp correction in gold prices will have a positive impact on the current account deficit.
CRR cut unlikely
A cut in CRR is unlikely at this juncture. The daily average cash deficit in the system was Rs.95,000 crore in calendar year 2012. It rose to Rs.1.11 trillion in March, but since then has dropped to Rs.85,000 crore in April. However, the core cash deficit is much lower, around Rs.25,000 crore, as the government’s surplus cash of Rs.60,000 crore has been lying idle with RBI. This money is not a part of the system. Once the government starts spending, the cash deficit will come down.
The cash deficit in the system will rise later because of record government borrowing, but RBI can always buy bonds from banks through its so-called open market operations (OMOs) to ease the pressure on liquidity. Last year it bought bonds worth Rs.1.55 trillion through OMOs.
The government will borrow Rs.5.79 trillion this year to bridge the fiscal deficit and about 60% of the annual gross borrowing is being raised in the first six months of the fiscal year. Net of redemption of old bonds, the net borrowing in fiscal 2014 is Rs.4.84 trillion.
So while a 25 bps rate cut is for sure, the CRR cut may have to wait. The rate cut could be laced with a less hawkish statement on the monetary stance, unlike in March when RBI cut the rate but dampened the market’s spirits with its guidance: “the headroom for further monetary easing remains quite limited”. It could follow it up with another rate cut in the next few months and bring down the policy rate to 7%. If it decides to bring down the rate at one stroke to 7% in May itself, that will be a bonus for the economy.
Will the cost of money be cheaper for companies and individual borrowers in the new fiscal? That’s a question only banks can answer.
In the past, they were reluctant to pare the cost of loans because they could not cut their deposit rates. With gold prices coming down, the flow of money into the banking system may increase and this will give the banks a handle to cut their deposit as well as loan rates.
More than a cut in the policy rate, RBI’s big challenge is managing monetary transmission.

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