Did RBI underprice upside risk to inflation?

The Reserve Bank of India (RBI) under Governor Shaktikanta Das, for the first time, acknowledged that inflation faced an upside risk, growth was slowing down and fiscal slippage was almost evident in the wake of large pre-poll announcements. Yet it did not move the needle much on how it was going to tackle all of these in the new financial year. What would be the size of its liquidity infusion in the system and which other tools it would apply apart from open market operations and foreign exchange swap to ensure there is an adequate fund with banks or other financial institutions to help transmission of rate cut to end consumers.

Secondly, its logic that central banks across the globe were easing rates and therefore the RBI should also do the same was not based on sound logic. In US and other countries, their central banks may be acting slow on rates but their situation is different. Their growth has fallen, industry is not doing well and long-term government bonds have fallen sharply. In India, on the contrary, we have a problem of fiscal slippage, transmission is a complicated issue, health of banking system is not sound and availability of funds with the banks remains a problem. In this scenario, should India follow suit with the rest of the world when it comes to monetary easing?

In the past the combination of fiscal slippage and monetary easing has made the country vulnerable. Yet closer to elections, the governor appeared giving a helping hand to the government. The growth slowdown could prove costlier to Prime Minister Narendra Modi, who won the last parliamentary elections 2014 on the back of the promise of creating 2 crore jobs every year.

The central bank listed several concerns, which emphasised they should have opted for a wait-and-watch approach. For example, it said beyond the near term, several uncertainties cloud the inflation outlook. Early reports suggest some probability of El Niño effects in 2019. There is also the risk of an abrupt reversal in vegetable prices, especially during the summer months, it said. It also recognised that the outlook for oil prices continues to be hazy, both on the upside and the downside.

In the wake of a reckless expenditure promise by the government and the opposition in the run up to elections, it also warned that fiscal situation at the general government level required careful monitoring. Yet, the central bank chose to cut the rate and prepared a perfect recipe for a post poll calamity when the government would raise taxes for citizens should it adhere to its pre-poll doles and, the RBI will tighten interest rates making it difficult for businesses.

But Das said he did not want to presume that the next budget would not be a tight one and that there would be a fiscal slippage. And based on that assumption, he gave a cut.

Sluggish growth across both Advanced and emerging economies is the key risk for the country as demand for exports moderates, Edelweiss Research said. However, a dovish turn by major central banks including the Fed, ECB, PCOB and BOJ may be beneficial for the foreign capital flows into the country. Moreover, rising disposable incomes of household due to the FY20 budget benefits may act favourably on consumption spending going ahead.

Another rate cut possible

Franklin Templeton predicted another rate cut of 25 bps if inflation continued to remain benign and growth projection were revised downwards. However, the timing of such a rate cut will be contingent on the incoming data. In line with the above, we expect the yield curve to steepen further. Even though additional rate cuts will bring down short-end rates, fiscal pressures are likely to keep the long bond yields at higher levels, it said.

But three consecutive rate cuts may spell another disaster. Besides fiscal issues, India needs to create more savings to get the economy going. Back-to-back cuts could hit savings and the country may eventually have to depend on current account deficit to service savings-investment gap. The new government will present a full Budget in July. The RBI must wait to see how the monsoon is panning out and also the uncertainty surrounding oil prices before handing out another rate cut.

To sum up, global economic activity was witnessing a synchronised deceleration, though easy policy stances by the fiscal and monetary authorities in several economies were expected to cushion the pace of the slowdown. The global trade outlook too was uncertain as the largest economies of the world struggled to strike a deal. Inflation pressures across geographies remained benign on soft commodity prices and slowing demand but a long term outlook was that of upside risk.

Global growth and trade concerns were expected to remain the dominant theme of 2019, which would drive markets and condition future monetary and fiscal actions. In that backdrop, the RBI may have reduced the repo rate by 25 basis points but it needed to take a close look on its stance, which remained neutral contrary to the market expectation. The markets wanted an accommodative stance. RBI may have thought that neutral stance was the best bet as it gave them freedom to cut or hike in the future. Both the monsoon risk and election outcome pose an upside risk to inflation.

Bond market will be closely following the election outcome and the inflation trajectory. Election outcome will have a bearing on government’s fiscal stance and which way the yield curve moves. Whichever government comes next, the bond markets perceive a risk of increased bond supply in 2019-20 as both major political parties have announced plans to dole out money to farmers.

“Since this important event (RBI policy meet) is behind us, the market trend, going forward, will be influenced by the capital flows into the market. So long as the Fed and ECB remain dovish, more flows can be expected into the market, which can impart resilience to the market. However, high valuation of markets remain an area of concern,” according to V K Vijayakumar, chief investment strategist at Geojit Financial Services.