ICRA expects the Reserve Bank of India (RBI) to leave the repo rate unchanged in the August 2016 policy review. The Agreement on the Monetary Policy Framework of the Government of India (GoI) and the RBI, signed in February 2015, had set a CPI inflation target for FY2017 and all subsequent years of 4% +/-2%. CPI inflation printed at 5.8% each in May-June 2016, close to the upper end of this band, suggesting a low likelihood of a cut in the repo rate in the upcoming policy review.
Aditi Nayar, Senior Economist, ICRA Limited, said, “Regardless of the imminent appointment of the Monetary Policy Committee (MPC) that would determine the policy rate required to achieve the inflation target going forward, and the appointment of a new RBI Governor, we expect lower CPI inflation in H2 FY2017 to create space for additional monetary easing of only 25 bps in 2016, if the prevailing inflation targeting framework continues unaltered. Moreover, with economic growth expected to pick up, sharper rate cuts may not be needed.”
The inflation target is yet to be notified, subsequent to the Finance Act, 2016, which has reignited the debate regarding the appropriateness of the prevailing target, given that the CPI basket is dominated by food items over which monetary policy has limited influence, the volatility of this series, and the sharp wedge between the CPI and WPI inflation.
“While switching to the WPI may allow for immediate rate cuts, this may reverse subsequently with the anticipated rise in WPI inflation. Regardless, with the composition of the WPI Index heavily weighted towards tradable items whose prices tend to track global trends, it may not be a more appropriate inflation anchor than CPI inflation. Moreover, WPI inflation tends to undergo revisions more often and by a higher magnitude, than CPI inflation“, she added.
ICRA expects CPI Inflation to rise marginally from an average of 4.9% in FY2016 to 5.1% in FY2017. Unless commodity prices slip appreciably, WPI inflation would rise in the coming months as the base effect fades, and average at a significantly higher 3.0% in FY2017 compared to (-)2.5% in FY2016. As a result, the wedge between CPI and WPI inflation is likely to progressively narrow over the course of FY2017.
In the 16 months between January 2015 and April 2016, WPI inflation was revised downward seven times by 5-56 bps each, and upward eight times by 5-45 bps each. Compared to this, the CPI inflation was revised on six occasions by 8-9 bps each over this 16-month period.
Indian CPI inflation has moderated substantially from 9.9% in FY2013 and 9.4% in FY2014, to 5.9% in FY2015 and 4.9% in FY2016. However, the monthly trend is fairly volatile, with a series of spikes and dips led by inflation for food & beverages and the associated base effects. Core-CPI (excluding food & beverages and fuel & light) is less volatile than headline CPI inflation. In the trailing 12 months, core-CPI inflation has fluctuated in a range of 80 bps, as compared to 210 bps for inflation for the headline CPI index. However, core-CPI may be too narrow for inflation targeting as it comprises less than half of the CPI Index.
Increasing the upper limit of the CPI inflation target above 6% may also not be appropriate. The higher the tolerance for inflation at the retail level, the higher the interest rates that savers would demand to remain invested in financial savings, which would ultimately impair the appetite for borrowing. Given the substantive changes related to the MPC that are already on the anvil, ICRA cautions against any major change in the inflation target, despite the shortcomings of CPI inflation.
Going forward, development of a credible, high frequency indicator of growth in both industry and services, may offer a surrogate for comprehensive data on unemployment in India. This may allow the RBI to eventually adopt a dual objective in place of the current framework of flexible inflation targeting.
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