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Over the past couple of years, the central bank has not cut rates significantly, for a variety of reasons. Though core inflation (non-food manufacturing inflation) started softening a while ago, the central bank held on to rates as the both fiscal and current account deficits, along with consumer price inflation, stayed above its comfort zone. Now, it seems the central bank will have little reason to justify its hawkish stance.
For starters, the fall in crude oil and gold prices would have a positive impact on the current account deficit (CAD). Lower crude oil prices have the potential to shave off 50 basis points (bps) from the headline inflation print during the year. Barclays expects CAD to moderate to a little over three per cent of gross domestic product over the next three years, much worse than the long-term average of 1.5 per cent. Siddhartha Sanyal and Rahul Bajoria of Barclays Economics Research expect the commodity import bill to moderate in the near term, reflecting a relatively benign commodity price outlook, subdued domestic growth and likely softer inflation.
As global commodity prices continue to soften, economists are factoring in a lower-than-expected trajectory for headline inflation. Given that commodity prices are expected to stay soft through the year, economists are back to the drawing board working on inflation projections for the new financial year. Last year, the wholesale price index (WPI) averaged 7.4 per cent, and the earlier projections expected it to average between six and seven per cent. Now, it seems the WPI print for FY14 could be below six per cent. Kotak's chief economist, Indranil Pan, says: "Our revised inflation trajectory factors in the weakening momentum of WPI and current softer bias for commodities, indicating an average of 5.5-6.0 per cent for FY14 against 7.4 per cent in FY2013."
The markets have factored in a 50 bps rate cut by June. While some believe it will happen in May others feel the rate cut cycle will accelerate in the first half with two cuts of 25 bps each. Bank of America Merrill Lynch expects Reserve Bank of India (RBI) to cut 25 bps on Friday, even as it expects the apex bank to caution that room for further cuts would be limited. However, for effective transmission of the rate cuts, the central bank will have to ease liquidity conditions. To do this, it will have to either cut cash reserve ratio by 25 bps or commit to open market operations of Rs 1.4-1.6 lakh crore in FY14.
