IN: Inflation and shifting policy dynamics 10 October 2014

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IN: Inflation and shifting policy dynamics
DBS Group Research 10 October 2014
Economics
Radhika Rao (65) 6878-5282 radhikarao@dbs.com
The RBI is likely to hold rates steady through March 2015
The FY16 inflation target faces upside risks on recovery expectations
and potential supply shocks
This backdrop will keep the RBI cautious in the early part of the year
Policymakers will also be mindful of changes to the monetary policy
framework, expected in late-2014
Indias CPI inflation trajectory will be distorted by base effects over the next
six months. This will keep the Reserve Bank of India (RBI) from rushing into
rate cuts. The upcoming changes to the monetary policy framework, pace of
recovery in aggregate demand and other disinflationary impulses will influ-
ence policy direction into FY16. Assuming the present CPI targets (Chart 1) are
maintained, we expect the status quo on rates to extend through March 2015
and perhaps significantly further into the year.
Inflation path over the next six months
September CPI inflation will likely ease to 7% YoY from Augusts 7.8%. This
marks a significant slowdown from 8.8% in January 2014. Inflation readings
are expected to soften further in October and November, reaching 6%, with
core inflation already slipping to fresh lows.
Falling inflation is encouraging but part of this is due to base effects. Due to
last years exchange rate and vegetable price volatility, such effects imply con-
siderable volatility between October 2014 and March 2015.
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% YoY
DBSf
RBI inflation targets
Chart 1: CPI inflation trajectory vs RBI nominal targets
IN: Inflation and shifting policy dynamics 10 October 2014
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The RBI clearly does not
want to jump the gun and
have to reverse course later
The initial downswing will take inflation to 6.0% by November, with downside
risks, owing to moderation in fruits and vegetables prices. However, fading
base effects thereafter will take headline inflation back to 8% by March 2015.
The magnitude of rebound will also be influenced by the filtered-through im-
pact on food prices from uneven southwest monsoon and an unexpected jump
in global commodity prices.
As inflation falls, the RBI is likely to face mounting pressure to ease rates. The
central bank has made it clear, though, that it will not be swayed by base-effect
distortions. The RBI clearly does not want to jump the gun and have to reverse
course later.
Upcoming changes to the monetary policy framework, discussed below, will
also influence rate decisions.
Inflation drivers into FY16: many moving parts
The RBI released its first detailed Monetary Policy Report at its September rate
review, including its long-term inflation and growth outlook. Its outlook on
growth is cautious, expecting the economy to expand 5.5% this year and 6.3%
in FY16. On inflation, the authorities are confident of meeting the January
2015 target but see upside risks to the early-2016 goal of 6.0%.
We are more positive on the growth outlook this year and next, with GDP
growth expected to quicken to 6.0-6.5%. The implied narrowing of the output
gap is likely to keep inflation elevated. We estimate FY16 inflation at 7%, with
headline inflation to be 6.8-7.0% in Jan16.
Our underlying assumptions regarding inflation are:
i) assuming normal rainfall, foodgrains and oilseeds supplies should remain
adequate. Volatile fruits and vegetables remain a key risk;
ii) manufacturers pricing power and consumption demand returns gradually
(Chart 3), as industrial output gains momentum into FY16. The narrowing
output gap should raise price pressures;
iii) minimum support prices (Chart 2) for agricultural produce will be raised
further, but the scale will be moderate as was the case in FY15;
iv) global crude prices are expected to recover from present lows to USD 95-
100pb, accompanied by a stable rupee.
Revival in aggregate de-
mand to stoke price pres-
sures
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15
30
45
0
200
400
600
800
1,000
1,200
1,400
1,600
2006 2008 2010 2012 2014
MSP - common paddy (LHS) YoY change
Chart 2: Min support prices - marginal rise in FY15
INR/quintal
% YoY
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Cost of raw materials Cap utilisn
expecns, Next qtr
Chart 3: RBI survey -Cap U, Selling prices to inch up
IN: Inflation and shifting policy dynamics 10 October 2014
3
Changes to the monetary
policy framework warrant
attention
Risks to our inflation outlook stem from external energy and domestic food
price shocks. Global crude prices are near two-year lows. A 10% decrease in
prices of the Indian basket of crude oil below the assumed levels would lower
headline inflation by 20bps, according to the RBI. In addition, a delay in GDP
recovery would help cap price pressures.
Monetary policy outlook under the current framework
In the last two rate reviews, there has been concerted effort by the RBI to shift
away from the short-term January 2015 goal at 8.0% and instead focus on
January 2016s 6.0% This tells us two things.
Firstly, the RBI is keen to mould inflationary expectations and back its inflation-
fighting credibility. Secondly, were the RBI to cuts rates (say, in response to
sub-8% inflation), it would be telling markets it is comfortable with the present
price outlook. Instead, by pushing the focus to 6%, the central bank is empha-
sizing that the fight against inflation is not over yet.
Hence, we maintain that the central bank is in for a prolonged pause on the
policy front, through FY15. There is also scope that the on-hold stance is main-
tained through 1H FY16, with rate cuts likely in second half subject to the infla-
tion outlook and US rates direction.
Externally, volatility is likely to heighten as the markets price-in US rate hikes.
Even as the USTs and Indian rate differentials are wider than the long-run aver-
age (Chart 4), we believe the RBI will be wary of lowering policy rates in the
face of higher US rates.
Notably, this policy call holds in the current policy environment. In this regard,
an eye needs to be kept on the overhaul of the monetary policy framework
later this year. Any change in the guide posts would change the response ac-
cordingly.
Upcoming changes
Recent indications are that the government and the RBI will outline a new
monetary policy framework later this year. This follows Finance Minister Arun
Jaitleys remarks at the July Budget on the need for a modern policy framework
to meet the challenge of an increasingly complex environment.
In this regard, recommendations from the Urjit Patel Committee report and the
Financial Sector Legislative Reforms Commission (FSLRC) will be used as the key
guide posts.
RBI has taken a serious
view on moulding inflation-
ary expectations
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Spread IN 10Y - US 10Y IN 10Y bond yield US 10Y bond yields
% pa, bps
Chart 4: Bond spreads between IN and US 10y government papers
IN: Inflation and shifting policy dynamics 10 October 2014
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Key changes are on the cards. Firstly, the Finance Ministry and the central bank
are expected to sign a formal agreement under which the government will ar-
rive at an inflation target, with inputs from the central bank. This framework is
likely to be officially adopted at the December RBI rate review.
For now, the Urjit Patel Committee recommends inflation targets of 8% by
January 2015 and 6% by January 2016. Thereafter, inflation is expected to sta-
bilise around 4%, with a +/- 2% corridor. It remains to be seen whether the
government will stick with these nominal targets.
Secondly, policy decisions will be undertaken by a monetary policy panel, led by
the RBI Governor. This marks a departure from the current practise where the
decision in taken solely by the Governor and factors in non-binding views of an
advisory group along with inputs from other department heads.
Some compromise will be needed on the composition of the panel. The govern-
ment prefers the panel to have a majority of external members. The RBI instead
has made a case for at least 3 of the 5 members to be central bank representa-
tives.
Thirdly, outside the policy paradigm, plans are to form a nine-member panel to
set out the blueprint for an agency that would manage government debt. This
responsibility currently rests with the central bank.
Overall, these changes are positive and take the Indian monetary policy regime
closer to global practices. These will also enhance the central banks indepen-
dence and lay the ground for a clear focus on inflation-targeting. At the same
time, bank communication will have to be tightened to ensure that it is consis-
tent, clear and minimises ambiguity in rate decisions.
From a policy perspective, it will be important to see whether nominal CPI infla-
tion targets are revised or retained, which will accordingly influence the rates
trajectory. We expect the Repo rate to be held unchanged in FY15 and first half
of FY16, assuming RBIs present indicative CPI inflation targets are retained.
Sources:
Data for all charts and tables are from CEIC Data, Bloomberg, RBI and DBS
Group Research (forecasts are transformations).
It is unclear whether the
government will retain the
CPI targets or make changes
IN: Inflation and shifting policy dynamics 10 October 2014
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