India shifts to monetary policy easing as inflation retreats

January rate cut ends 20 months of tight monetary policy

The repo rate cut was the first by the Reserve Bank of India (RBI) in almost two years. It was back in May 2013, when the RBI last intended to aid India's flagging economy by cutting the leading repurchase (repo) rate by 25 basis points to 7.25%, despite the persistent near double-digit consumer price inflation. Undermined by the government's policy paralysis and the soured investor confidence, the RBI's efforts failed to save the economy from a further slide into the crisis, which fully unfolded in the following months with the round of steep currency depreciation. Driven by the need to arrest the rupee's free-fall, the RBI had raised the repo rate by 75 basis points during July 2013–January 2014, and maintained it at 8% thereafter, despite the increasingly strong demands from the government and business community to lower interest rates.

Not surprisingly, rising borrowing costs for consumers and businesses alike continued to constrain economic activity. The real GDP growth, which had consistently showed rates above 9% early in the last decade, remained under 5% (on a factor cost basis) for the second straight year in fiscal year (FY) 2013 (ended March 2014). Even with the rise in business confidence following the election of a new pro-reformist government of Narendra Modi in May 2014 and the new government's measures to revive investment and manufacturing, the economic recovery has proceeded slowly. The real growth improved to 5.5% in first half of FY 2014, but domestic demand remained muted, with real fixed investment failing to show any expansion in the September 2014 quarter (see India: 2 December 2014: India's Q2 GDP growth slows less than expected, but weak investment still points to wobbly recovery). Manufacturing activity also remained weak, clocking a disappointing 0.4% y/y growth during the first 11 months of 2014.

Inflation should not be a near-term concern, likely facilitating additional policy easing

The RBI's decision followed the release of better-than-expected retail and wholesale inflation readings earlier in the week. In its previous analyses, IHS indicated that the December inflation data would be a critical point for the RBI's governor R. Rajan to decide on the timing of the first interest rate cut (see India: 16 December 2014: Wholesale prices in India remain flat in November supporting case for interest rate cut). The December inflation data was expected to end a several-month-long easing trend, given the anticipated uptick in food inflation and less favourable base effects from the last year. As expected, CPI and WPI readings showed an uptick in annual inflation, with consumer prices rising 5.0% year on year (y/y) in December, up from 4.4% y/y in the previous month and with wholesale price inflation inching up marginally to 0.1% y/y. However, the acceleration was below the expected rates, particularly for the WPI, while both indicators continued to decline in month-on-month terms. Besides, manufactured goods inflation (often used as the core inflation measure in India) declined to a six-year low of 1.6% y/y in December, reflecting a continued weakness in demand conditions. Inflation expectations have also followed suit, with the RBI's household expectations survey showing near-term and longer-term inflation expectations easing to single-digits for the first time since September 2009.

To a large extent, easing inflation has been driven by large declines in fuel and power prices, with world oil prices having tumbled 55% (Brent crude) in 2014 on consistent over supply in world oil markets. India's domestic fuel and power prices have long been administratively controlled and had subsidies from the government. Yet petrol (and partially diesel) prices have been market-determined since 2010, which allowed for at least partial passing on of the gains of weaker global oil prices to domestic consumers. Besides, the new BJP government started another round of fuel price deregulation in November 2014, allowing further movements in global oil markets to directly influence domestic fuel prices. With global oil prices remaining on a downward spiral, India's headline inflation should remain contained in coming months. In addition, food price developments have been also more favourable than anticipated. Despite a week monsoon season, pressure on prices of vegetables and staple cereals declined sharply since September 2014 and even as a mild uptick in food inflation is expected in coming months, food inflation should remain contained, particularly as the government accelerates its efforts to improve distribution channels and boost supply, helping to bring structural inflation down over the medium term. Ultimately, bringing the structural inflation down is what the RBI's goal is and further policy easing will likely increasingly emphasise the need for more supply-side reforms.

Rate cut come as a relief for businesses and consumers alike

The beginning of an easing policy cycle has been long awaited by investors and the manufacturing sector and has come as welcome news. Even as financial markets have been already pricing in the rate cut in early 2015, Indian stocks, bonds, and the rupee surged after the policy announcement on 15 January. The benchmark BSE Sensex index rose 2.7% and the rupee strengthened as much as 1.1% to INR61.49 per USD, the strongest since November 2014. The yield on the benchmark 10-year sovereign bond dropped eight basis points to 7.69%, the lowest since July 2013. Going forward, the cut in the repo and MSF rate should translate into the fall in borrowing costs by banks that in turn are expected to pass on the benefits to borrowers in the form of lower lending rates. So far, credit demand has remained weak for the most part of FY 2014, with private sector credit growth having slowed to 10.5% by end-December 2014, from 14.2% a year ago.

Cheaper borrowing costs should help boost investment and revive manufacturing sector growth. Indian consumers, too, are seen benefitting from lower interest rates. Consumer demand remained subdued even over the traditionally strong festival season, with industrial output data showing a severe contraction in consumer goods output over the past 18 months. Consumer goods output shrunk 1.7% in 2013 and continued declining every subsequent month of the last year with the exception of May, with the latest reading for November showing 2.2% y/y contraction despite the generally favourable overall industrial output trend. Contraction has been most severe in consumer durable goods, as Indian households put off any non-essential spending due to concerns over the weakening economy and high credit costs.

Outlook and implications

Yesterday's move is likely to be the first in a series of cuts in the next 12 months. During the December policy meeting, R. Rajan signalled a shift to an easing policy cycle, stating that subsequent policy actions would be consistent with the first change in policy stance. The timing and extent of further cuts will likely depend on the fiscal and external developments and remain conditional on favourable inflation dynamics. The government is expected to deliver its new budget for FY 2015 in February. For the current year, the government set its fiscal target at 4.1% of GDP and, although so far the gross fiscal deficit already reached 99% of the target by November 2014, a seasonal pick-up in tax collections, improvements in corporate profits, and fuel subsidy cuts could help bridge the gap by the end of March 2015 – the end of India's fiscal year. Nonetheless, should the deficit target be overshot significantly or should the new budget be less credible than expected, this could derail the RBI from the set policy easing path.

Meanwhile, the developments in the US and the global financial markets reaction will also play its role. So far, the Indian rupee remained among the most resilient emerging markets currencies in 2014, supported by the improving investor sentiment and the rally in Indian capital markets following the election in May. However, following a sharp rebound shortly after the election, portfolio investment has eased in the December quarter and although fundamentally the accelerated reform momentum should keep foreign capital flowing into India, the expected interest rate hike by the US Federal Reserve could trigger renewed volatility in the capital markets in the second half of 2015. Inflation, albeit likely remaining well below the central bank's target, could also experience an uptick towards the end of the year, suggesting that the window of opportunity for the RBI to further cut interest rates is greater in the first half of the year. Taking this into account, we believe the RBI's initiated policy easing cycle will be front-loaded, with additional interest rate cuts likely to be packed before July. Overall, we expect the RBI to deliver as much as 100 basis points in rate cuts this year. Coupled with the government's efforts to revive investment, this should help India's economy to clock a projected growth of 5.9% in the year ending March 2015, further recovering to 6.7% in fiscal year 2015/16.