The Indian government set the inflation target at 4% with plus or minus 2% until 2021 in line with the report of Urjit Patel Committee, appointed by the Reserve Bank of India (RBI). However, reaching and sustaining inflation at 4% may not be easy and this time, there will be no rate cut says Kotak Economic Research in a research note.
"Even as inflation may moderate further, the expected inflation trajectory is unlikely to sustain around the 4% mark. While we continue to factor in another 25 basis points (bps) rate cut for the rest of FY2017, we are cautious on the FY2018 rate cycle. We would factor in further cuts only after clarity on the pace of disinflation in fourth quarter of FY2017 and RBI's new policy regime. We expect the RBI to pause on 9th August," the report says.
The government has set the inflation target at 4% with plus or minus 2% until 31 March 2021, effective from 5 August 2016. Kotak says, "This is a positive step towards making the government an equal partner to ensure a low and stable inflation environment. The government has already notified the creation of the Monetary Policy Committee (MPC), which will comprise three members appointed by the government for four years apart from the RBI Governor, Deputy Governor and a senior official of the RBI. The government is likely to nominate the MPC members as well as appoint the new RBI Governor after the 9th August monetary policy meeting."
Although the government has set inflation target, Kotak feels reaching and sustaining inflation at 4% may not be easy. It says, "Our estimated trajectory indicates moderation towards 4.0-5.0% but sustaining it at 4% will be difficult even without factoring in statistical impact on housing due to seventh Central Pay Commission (7CPC). The pace of disinflation, through our estimated structural drivers like rural wages, money supply, exchange rate, output gap, and minimum support prices (MSPs), have moderated. Rural wages, which is one of the most influential variables, has settled at 4-5% increase over the past two years. Money supply growth has been weak but unlikely to contribute much further. Most of the disinflationary impulse on food has played out through lower global prices and stable MSPs. Some cyclical downside could come through higher output due to better monsoons."
"Historically, a stable 4% level was seen in early 2000s and was accompanied by lacklustre rural demand. Incremental increase in allowance component in 7CPC and the related pickup in urban demand along with monsoon-related rural demand pose upside risk," it added.
Kotak says it is cautious on further rate cuts in FY2018 with an outside chance of 25-50 bps. It says, "For FY2017 we maintain our call for a further 25 bps rate cut. However, as highlighted earlier, we are not yet confident of the inflation trajectory gliding towards 4% and sustaining at it."
"On the other hand," it added, "the collective thought process of the new monetary policy regime (MPC and new Governor) will be important in gauging how the RBI looks at attaining the target. We expect the RBI to remain focused on achieving an inflation rate closer 4% and keep inflation expectations under check. This necessarily will imply that the scope for rate cuts is limited though the liquidity channel will likely remain accommodative as RBI continues to keep liquidity closer to neutral on average. We expect the RBI to remain on a pause in 9th August policy."
Talking about bonds, the report says, affirmation of the inflation target and long-term prospects of adhering to low inflation is a positive for lower rates in the long term. "Since the Brexit outcome, domestic bonds have rallied in tandem with global bonds. Even though the markets may not have much to cheer from the policy rate trajectory, comfortable domestic and global liquidity will be positive for bonds. On balance, there are marginal downside risks to yields and we maintain our range of 7.00-7.25% for the rest of FY2017," the report from Kotak concluded.