An inflation number below 4% for August may well prompt the RBI to reduce the policy rate

RBI Watch                                                                                    Monetary Policy 2015-16

The August CPI inflation number should be out in another two weeks. If the number is below 4%, just like the July number, then I believe the RBI will seriously consider another 0.25% cut in the repo rate.

The RBI expects inflation to fall to 4% and then increase to 6% by January 2016. In this scenario, a repo rate of 7.25% is appropriate, given RBI’s real interest rule of 1.25 to 1.5%.

If however inflation consistently undershoots the 4% level, then the RBI will revise downwards its projected level of inflation for January 2016. Once this happens, the RBI will be open to another cut in the repo rate. A projection of inflation at 5.75% or lower by January 2016 will give room to cut the repo rate by another 25 basis points to 7%.

Let’s also look at the real economy at home and abroad.

Demand conditions continue to be weak. The latest GDP number for Q1 of 2015 at 7% suggests that there has been some deceleration in the economy, and the economy is unlikely to achieve the target of 8% GDP for 2015-16 set by the government. China’s economy continues to slow. Both the USA and Europe show signs of slow growth. The inflationary environment is exceptionally benign in most of the world. Commodity prices, including oil, have fallen sharply.

All this suggests that inflation, even if it trends up in the coming months, will remain benign and I expect the level to be below 6% in January 2016. Looking back, since September of last year, inflation has consistently held below the 6% level.

Yet, there are two sources of worry for the RBI: the potential for a China contagion and the imminent Federal Reserve’s move on the repo rate. Will the slowdown in China lead to financial market instability, and will this spread to India? Last week’s sharp fall in China’s equity markets rattled financial markets, although some semblance of stability returned by the end of the week. But let us be clear that the China uncertainty factor has a long way to go before it clears up.

Two, how will investors respond if the Federal Reserve decides to raise the federal funds rate at the FOMC meeting on September 16-17? Even if it does not, and my sense is that the Fed will not raise the repo rate at this meeting, it is only a matter of time before the Federal Reserve begins to normalise interest rates. Some adjustment on this front has already been made by investors and corporates, as the Fed had made its intentions clear for about a year. However, a combination of a possible China contagion and an increase in US interest rates may spook investors.

As these events unfold, the rupee could weaken sharply, there could be significant outflow of FX reserves, and money market conditions could tighten. As volatility increased in the financial markets last month, call money rates in India rose by 0.5%.

Despite these factors the RBI may still go ahead and reduce the repo rate in September, but future moves may be put on hold. The RBI could well justify this on the ground that banks have not fully passed on the RBI’s cuts in the repo rate (banks have reduced the base rate by about 0.3%, although the RBI has cut the repo rate by 0.75%), and that the RBI’s next move would come only when this has happened.