 "Indranil SenGupta")
We are happy that Reserve Bank of India (RBI) Governor Raghuram Rajan paused today (Tuesday). Although growth has bottomed out, we don't see recovery beyond the current anaemic 4.5-5 per cent until interest rates come down. Retail inflation has also peaked off, although the hailstorm is putting some pressure on food prices.
Looking ahead, we expect CPI-based inflation to come off to seven per cent levels if the rains are normal. This will likely allow RBI to cut rates by 50 basis points by end-2014. In our view, core CPI-based inflation will remain stuck at about eight per cent, above its medium-term 7.1 per cent average, as long as housing price inflation is reported at 10 per cent. Anecdotal evidence suggests that rentals are growing much slower: A five per cent swing in housing price inflation impacts core retail by 120 basis points.
The future path of CPI-based inflation turns on the south-west monsoon. The Southern Oscillation Index, a lead indicator, has dipped well below the -8 mark that signals an El Nino, the heating up of the Pacific that drives rain clouds from India. If El Nino strikes by the summer, India will most probably see a drought that will then likely stick CPI-based inflation at 8-10 per cent. Although monetary policy cannot fight dry skies, we expect RBI will not take chances with inflation expectations. This might push rate cuts to early 2015.
Finally, we are relieved to find that RBI has begun to recoup forex reserves at about 60 a dollar. After all, import cover, at 7.5-8 months, is well below the 10 months that is typically needed for rupee stability. This is the right time to accumulate because sentiment in the forex market now favours the rupee among the 'Fragile Five'. We expect RBI to hold 60-65 per dollar if the dollar settles at around 1.30 against the euro.
Indranil SenGupta
India Economist, Bank of America Merrill Lynch
