The latest Consumer Price Index (CPI) data are just out and are unambiguously positive. The CPI on a year-on-year basis is down to 5.5 per cent in October from 6.5 per cent in September (below consensus expectations of 5.8 per cent). This is the slowest pace of rise in inflation since the new series was launched in January 2012. The easing in inflation has been in large part due to the recent fall in food prices (food accounts for 50 per cent of the CPI). Food inflation accounted for about 2.9 per cent of the inflation number in October compared to 3.8 per cent in September. In contrast to this, core inflation remained stable in October at about 5.7 per cent. Inflation is now well below the Reserve Bank of India (RBI)'s target of eight per cent by January 2015 and has even slipped below the January 2016 target of six per cent.
Given how weak the economy is, and the desperate need for balance sheet repair among large swathes of corporate India, there is a growing drumbeat of voices and opinion pushing for a rate cut from the RBI. From corporate chiefs to the finance minister, everyone is convinced that the time has come to lower rates. Rate cuts will kick-start the investment cycle, lift the economy, boost stock markets and enthuse sentiment. Now that its targets have been met, why should the RBI hesitate? So goes the thinking. Stock markets are starting to believe that rate cuts are imminent, with some sharp investors even expecting a move in December itself. Offshore markets are now pencilling in a very high probability of a rate cut in early 2015.
While I can see the rationale, and at the expense of getting brickbats from fellow equity investors, in my humble opinion, it may still be too early and risky for the RBI to move on lowering rates.
I think the biggest and most impactful reform (for the long term) of 2014 has been the explicit move by the RBI towards flexible inflation targeting. Coming on the heels of more than five years of double-digit CPI inflation and increasingly entrenched inflation expectations, the RBI needed to get ahead of the curve and put the inflation genie back in the bottle. Jettisoning the multiple-indicator approach, the RBI has made it clear that henceforth, the overwhelming objective of monetary policy would be to keep the CPI inflation within a predetermined band. Growth would also be pursued, but only to the extent it did not interfere with the inflation objective. Inflation expectations were getting unhinged, creating a self-reinforcing cycle, and this spiral had to be broken. The only way to break this cycle was to convince households and other economic players that the RBI was serious about inflation and would bring it down structurally. Hence, the focus and targeting of headline CPI and not core. After all, headline CPI is what households consume and understand. To change inflationary expectations, households have to both understand and believe in the targets.
While everyone is getting excited about the recent fall in inflation, how sustainable is this? After all the RBI has a target of six per cent by January 2016 and then longer term four per cent, within a two-per-cent band. Has enough been done to take us towards this four per cent target? Inflation right now is benefiting from some short term tailwinds, namely, oil price correction, favourable base effects, a normalisation of the monsoon and some tactical supply-side moves by the government. Can we really say we are on a sustainable path to four per cent or even six per cent with any degree of confidence?
To get inflation down to the RBI targets, durable food dis-inflation is critical. Accounting for almost 50 per cent of the CPI basket, over the last eight years food inflation has averaged over 10 per cent and has been the key cause of the CPI surge. In this time, every major food group - cereals, pulses, fruit and vegetables, and proteins - has seen near-double-digit price rises. The ubiquitous nature of the price rise indicates a very fundamental mismatch between demand and supply, which can only be addressed with serious policy reform. In the absence of fundamental reform in this area how can one make a bet that food prices will come down on a sustainable basis. Without stability in food prices the RBI inflation targets are unattainable.
Fundamental food reform involves improving agricultural productivity, changing procurement policies and pricing to incentivise production of non- cereals, reforming the state agricultural produce market committee acts, improving post-harvest infrastructure and improving price signals to farmers by reducing the number of intermediaries from farmer to end-consumer. While the government has made a start by keeping minimum support price hikes in rice and wheat at only two per cent in 2014, nothing much else has been done yet. I don't see how anyone can have confidence that the days of double-digit food price rises are permanently over. Yes, rural wages are no longer rising by 15 per cent a year, but as Indian growth accelerates, demand for better food will continue to surge. We have yet to do enough on the supply side.
It is also difficult for the RBI to assume that oil and commodity prices will continue to slip or even remain at these levels. They can mean revert at any time, it is very difficult to make any type of forecast here.
There remain huge price distortions in the economy from water to electricity and fertilisers - as these normalise their impact on inflation can be significant.
It is also unclear whether we have built up enough of an output gap, that an acceleration in GDP growth will have no impact in quickening the pace of inflation.
Given the uncertainty in the global economy, and possible disruptions to emerging market capital flows as the United States Federal Reserve finally begins to normalise, the RBI has to be sensitive to global macroconcerns as it considers the timing of its monetary policy actions.
The RBI is trying to rebuild its credibility as an inflation-fighter and bring down inflation expectations across the economy on a sustainable basis. This will be a massive positive for asset markets, if the RBI succeeds. Price-earning multiples will expand, rates will come down across the system, economic volatility dampen and macro risk premiums reduce.
Given the huge upsides, of re-establishing credibility and getting the inflation genie back in the bottle, it is better for the RBI to wait until it is more certain, rather than cut now and have to scramble and possibly reverse course later.
Most investors may curse the RBI's caution today, but true long-term investors should welcome it.
The writer is at Amansa Capital. These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
