Economic Analysis - RBI To Maintain Repo Rate At 6.00% For Rest Of FY2017/18 - NOV 2017

BMI View: We maintain our average FY2017/18 (April - March) consumer price inflation (CPI) forecast at 3.5%, and we expect the Reserve Bank of India (RBI) to hold its benchmark repo rate at 6.00% for the rest of FY2017/18 due to rising inflation and expectations of an economic recovery in the second half of the fiscal year .

Rising inflation and positive high frequency economic data inform our decision to maintain our average consumer price inflation (CPI) and benchmark interest rate forecasts for FY2017/18 (April-March) at 3.5% and 6.00%, respectively. Headline CPI jumped to 3.4% y-o-y in August from 2.4% y-o-y in July on the back of higher food prices, and it is likely to continue on a gradual uptrend over the coming months. Additionally, positive high frequency data support our expectations for an economic recovery in H2FY2017/18 following a pre-GST slump in Q1, and when considering it together with inflation that is still within the Reserve Bank of India (RBI)'s medium-term inflation target range of 4.0+-2.0%, we expect the central bank to keep its benchmark repurchase (repo) rate steady at 6.00% over the coming months.

Inflation To Pick Up

We expect headline CPI to rise gradually through the second half of the fiscal year and lift average inflation towards our 3.5% forecast, which provides the RBI with little reason to change its monetary policy stance given that the figure lies within its 4.0+-2.0% inflation target.

Our Commodities team's bullish forecasts for oil and grain (corn and wheat) prices, along with adverse weather conditions seen over June and July, suggest that food and fuel prices are likely to trend higher. Additionally, non-food and non-fuel CPI is likely to rise. For example, housing costs appear likely to rise on robust demand and possible supply shortages under the 2016 Real Estate Regulation Act (RERA), while higher taxes for recreation and certain consumer goods (detergents, baby food, shampoo, etc.) under the new GST system implemented since the start of July will drive up household expenditures.

Inflation To Trend Higher
India - CPI Breakdown, % chg y-o-y
BMI, Bloomberg, MOSPI

Economy Likely To Recover in H2FY2017/18

Positive economic data support our expectations for an economic recovery in H2FY2017/18, which would reduce the impetus for the RBI to cut rates in an effort to support growth. We expect economic activity to gather pace in the second half of the fiscal year, and we forecast real GDP growth to come in at 6.4% for full-year FY2017/18 from 5.7% y-o-y in Q1FY2017/18 (quarter ending June), which will still place it among the highest for large emerging economies ( see ' Downgrading Growth On Weak Q1 Figure, H2 Recovery Likely ' , Sep tember 4). Indeed, manufacturing PMI rebounded into expansionary territory in August, coming in at 51.2 versus 47.9 in July, while industrial production grew 1.2% y-o-y in July compared to -0.2% in June. Furthermore, the Manpower Group's Employment Outlook Survey for Q417 sees a pick-up in hiring due to festive season demand, which suggests business sentiment is improving.

RBI Mopping Up Excess Liquidity
India - RBI Liquidity Absorption Operations

Excess Liquidity Discourages Lower Rates

The RBI is unlikely to derail its efforts in mopping up excess liquidity in the banking system by slashing interest rates. Demonetisation, along with intervention in foreign exchange markets to control the Indian rupee's appreciation amid an increase in foreign investment inflows, have resulted in excess liquidity in the banking system.

The RBI has been absorbing surplus liquidity through various mechanisms such as selling government bonds (Market Stabilisation Scheme), bank deposits (Standing Liquidity Facilities), and USD forward purchase agreements (USD Forwards). These are becoming increasingly costly for the RBI, which is halving dividend payments to the government in FY2017/18 due to higher operating costs, and is unlikely to implement any measures that could lead to a further surge in liquidity.