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The sharp fall in inflation over the past few months has raised the clamour for interest rate cuts. With the Consumer Price Index-based inflation falling to 5.5 per cent in October from 6.5 per cent a month ago, is below the central bank’s target of six per cent by January 2016, the pressure on the Reserve Bank of India (RBI) to loosen monetary policy is mounting. While so far RBI resisted pressure to reverse its stance, the decision to cut interest rates is likely to be guided by whether the moderation in inflation is transitory.
The recent slowing in retail inflation has been driven largely by food inflation, which fell from 7.7 per cent in September to 5.6 per cent in October, due to lower prices of fruits, vegetables and sugar. According to CRISIL, “The seasonally adjusted month on month momentum in food inflation was muted at 0.02 per cent.” This suggests the recent decline was largely due to the strong base effect. As food inflation averaged 13 per cent in September-December last year, it is likely to moderate further over the next few months on base effect. But this effect is likely to wear off. “While inflation is likely to come down over the next few months, it is expected to rise again early next year as the base effect wears off,” says D K Joshi, chief economist at CRISIL. ICRA estimates the base effect is likely to wear off by early next year and retail inflation is likely to revert to seven per cent by February-March. CRISIL expects inflation to average 7.2 per cent in FY15.
There are other factors also at work. A deficient monsoon is likely to impact agricultural output, which could impact food inflation in the coming months. “With the ministry of agriculture forecasting a lower kharif output for cereals, pulses and oilseeds, it could lead to some upward bias on inflation in coming months,” says Madan Sabnavis, chief economist at CARE Ratings. However, recent steps taken by the government like the decision to release grain from its stock and limiting the increases in minimum support prices (MSP) could, on the other hand, ease pressure on food inflation. Also, the sharp fall in global crude oil prices could act as a damper, easing inflation, especially in the transport and communication and fuel category. Crude oil prices for the Indian basket ended the month of October at $83.8/bbl as compared with $95.3/bbl at the beginning of the month.
The impact of these contradictory forces, whose outcome is difficult to predict, suggests RBI will adopt a wait-and-watch approach. “While inflation has come down much faster than expected to bring it firmly under control, RBI must continue with the tight monetary policy,” says Joshi. The anti-inflationary stance adopted by RBI is likely to help rein in household inflation expectations. This should prevent it from feeding into wage contracts, which could translate to more generalised inflation.
Although a rate cut will probably boost sentiment, Aditi Nayar, senior economist at ICRA, says “If monetary easing is undertaken in the immediate term, subsequent to which inflationary pressures undergo a resurgence on account of either exogenous factors such as global commodity prices or a sharper than expected revival in demand conditions, an early reversal of the monetary stance could impact the credibility of the inflation targets.” Thus, while the pressure on RBI to cut rates and boost growth is likely to intensify, according to Sabnavis, “RBI will reverse its stance only when it is convinced that the recent moderation in inflation is sustainable and not transitory.”
