By Invitation. Why rates may hold steady

As the next monetary policy review draws near, a new Governor is at the helm of the Reserve Bank of India (RBI) and a six-member Monetary Policy Committee (MPC) is broadly in place, ushering in a new era in monetary policy setting. Henceforth, the MPC would be entrusted with the task of setting the repo rate at an appropriate level to contain CPI inflation within the specified target, which the Centre has defined as 2-6 per cent up to March 2021.

CPI inflation has displayed considerable volatility in recent months, increasing from 4.8 per cent in March 2016 to 6.1 per cent in July 2016, before declining to 5.0 per cent in August 2016, on account of a favourable base effect and decline in prices of vegetables and pulses. Given the large weight of food items in the CPI basket, such volatility is likely to persist in the future as well, barring substantive supply-side improvements.

In the current year, monsoon rainfall has been weaker than the India Meteorological Department’s forecast. However, surplus rainfall in July 2016 permitted an augmentation of the area sown under kharif crops. Moreover, the first advance estimates of crop production forecast a considerable increase in output of most kharif crops, which would dampen food inflation over the next few months. Sugar prices are, however, likely to remain firm, given the unfavourable domestic production (October 2015-September 2016) and the muted outlook for sugar year 2017 (October 2016-September 2017).

We expect CPI inflation to chart a U-shaped trajectory in the remainder of FY2017, dipping further in the next few months and then rising from December 2016 onwards, partly on account of the unwinding of the favourable base effect. With average CPI inflation set to moderate to around 4.6 per cent in H2 FY2017 from around 5.5 per cent in H1 FY2017, there is room for another 25 bps rate cut in 2016. However, we expect this to be deferred to the December 2016 Policy Review, in spite of the lag in transmission of policy easing to bank lending rates.

Following the rise in core-CPI inflation in August 2016, the RBI may choose to observe the impact of the revival in domestic demand subsequent to the pay revision by the Centre, even though moderate capacity utilisation in many sectors would buffer inflationary pressures.

While the primary objective of the monetary policy is to maintain price stability, the objective of growth is also to be considered.

The remainder of this fiscal year is likely to witness a consumption-led pick-up in economic growth, benefiting from the positive impact of the pay revision by the Central as well as certain State Governments on urban consumption, as well as a revival in rural demand after the healthy kharif harvest.

Nevertheless, given moderate capacity utilisation levels and balance sheet constraints for various corporates, a broadbased uptick in private sector investment activity is unlikely to take root.

Other engines of growth are likely to remain sluggish.

Merchandise and services exports are expected to display muted expansion in FY2017, in line with the recent downward revision in the forecast for global trade.

So far, the pick-up in infrastructure activity remains concentrated in some sectors such as road execution, metro rail, etc.

Constraints on the fiscal space available with the Centre would also limit the direct budgetary support for capital expenditure.

The operationalisation of the National Investment and Infrastructure Fund (NIIF) is awaited to boost financing for infrastructure.

While funds raised through IPOs have recorded a healthy uptick in recent months, highly leveraged firms have not been able to raise equity.

Overall, growth of gross value added at basic prices is expected to record an uptick to 7.7 per cent in FY2017 from 7.2 per cent in FY2016, the performance would remain uneven across sectors.

In terms of transmission of the past rate cuts of 150 bps, the interest rates in the debt markets have responded far faster than bank lending rates.

Bond yields have corrected further in the ongoing quarter, partly on account of improved liquidity conditions and also in anticipation of further rate cuts.

This has contributed to robust growth of commercial paper (24.8 per cent) and bonds (15.3 per cent), as compared to the subdued YoY growth in bank credit to large industry and services of 3.2 per cent at end-June, 2016.

With a re-emergence of the seasonal tightness in systemic liquidity, additional open market purchases of Government securities of ₹500-600 billion in Q3 FY2017 are expected, as the central bank remains committed to reducing the structural liquidity deficit.

While the transmission of past monetary easing by the banking system would remain an area of focus, the pass-through is expected to be constrained by subdued profitability of the PSU banks.

The writer is Managing Director & Group CEO, ICRA Limited

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