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Make the cut

A waning supply shock in an environment of tepid demand affords RBI elbow room to wield the knife.

Written by Dharmakirti Joshi |
Updated: August 3, 2015 2:12:59 am
RBI, RBI monetary policy review, Raghuram Rajan, RBI rate cut,  crude oil prices, oil prices, monetary policy review, inflation,  energy prices, indian express column, ie column, Dharmakirti Joshi column The RBI has the best opportunity to cut rates before the US Federal Reserve starts moving the other way, which could be as early as September.

The RBI did not give explicit forward guidance on interest rates in its monetary policy review statement of June 2. But at an analyst call that followed, Governor Raghuram Rajan did highlight the risk of inflation because of a weak monsoon and a possible uptick in energy prices. He said, “…at this point, we are waiting for the monsoon outturn as well as the possibilities for movements in energy prices. As we get more confidence on the outturn, the government reaction, and energy prices, we will have a sense of what is possible on the policy front.”


Since then, rains have been better than expected and crude oil prices even more so. This waning supply shock, in an environment of tepid demand, affords the RBI elbow room to wield the knife when reviewing monetary policy on August 4.

To be sure, the latest print on inflation and industrial production has been a negative surprise. Consumer inflation crawled up to 5.4 per cent in June, primarily because of food items. Industrial production growth, at 2.8 per cent in May, was much weaker than expected. Poor demand also took a toll on corporate profits in the second quarter. So, circumstantially speaking, there is a case for a rate cut. The follow-up question, then, is: Will the recent rise in inflation, coupled with a rate cut, cause the 6 per cent inflation target for this fiscal to be missed?

Data on the monsoon, sowing patterns and global commodity price movements suggest that food inflation risks can be managed with proactive steps by the government. Despite the threat of a sub-normal monsoon, we expect average consumer inflation to decline to 5.8 per cent this fiscal from 6 per cent last year. That’s because headwinds from inadequate rains and the inflationary impact of the service tax hike could be offset by falling crude and commodity prices. And preemptive measures by the government — such as the use of buffer food stocks, imports and curbs on hoarding — could keep inflation within the RBI’s lakshmanrekha of 6 per cent for this fiscal. The tight leash on the fiscal deficit, and restrained hikes in MSPs, are also inflation positives.

The spatial and temporal distribution of the rain so far cannot be called normal, as there has been deficient rainfall in some parts of the country and the monsoons did falter in the first half of July. The jury on the monsoons is still out as the August rains are crucial. That said, the progress of the monsoon till July 30 has been better than predicted by the Indian Meteorological Department in June. Up till July 30, the rains have been only 4 per cent below the long-period average. The northwestern region, which accounts for 46 per cent of India’s foodgrain production, has received 12 per cent above normal rain so far.

Rains in Maharashtra — and in parts of Bihar, Uttar Pradesh, Karnataka and Andhra Pradesh — have been deficient, which puts at risk crops such as cotton, pulses, oilseeds and jowar. Inflation in pulses crossed 22 per cent in June after production suffered because of insufficient rain in 2014 and damage to crops from unseasonal showers in March this year. Add to that the threat of a second straight failed monsoon, and inflationary expectations in pulses took off.

Pulses are indeed a cause for concern today because there is limited scope for imports to plug the demand-supply gap. The good news is that the area sown under pulses till July 24 was 51 per cent more than last year, and 8 per cent higher than the normal area sown. Rising prices seem to have incentivised sowing, which should provide some relief.

The area sown under rice this year is higher than in 2014 but 3 per cent below normal. The government has sufficient buffer stocks to keep rice inflation under check. The area under oilseeds cultivation is more than both last year and what’s normal for this period. Then there is comfort in the fact that shortages can be met through imports because global edible oil prices remain subdued.

The rise in oil prices was a risk flagged by Rajan during the June policy review. But since then, crude prices have been trending down. West Texas Intermediate (WTI) slipped to $48 per barrel on July 24 from $60 on June 2, the day of the previous monetary policy review. During this period, Indian basket crude prices have fallen by $10, while steel, aluminium and copper prices slid 11, 7 and 13 per cent, respectively. Stunningly, WTI futures for June 2018 — yes, three years down the road — were quoting $59 per barrel a few days back. The refrain is that the US-Iran deal will keep crude prices low for some time.

The slowdown in the “resource-intensive” Chinese economy has had a disproportionate impact on commodity prices. The IMF has forecast Chinese GDP growth to slow to 6.8 and 6.3 per cent in 2015 and 2016, respectively. Thus, the downward pressure on commodity prices is likely to continue.

It is true that food has a much higher weightage in the consumer price inflation basket and is currently displaying some signs of stress. But the fall in crude and commodity prices, and encouraging signs on the sowing front, offer respite.

This provides the RBI with the best opportunity to cut rates before the US Federal Reserve starts moving the other way, which could be as early as September. And, like last year, we may succeed in putting a lid on food inflation this year, too, even if the monsoon is not supportive. But repeating this feat every year is not possible without structural improvements in agriculture.

As per the new monetary policy framework, controlling food inflation is central to meeting the RBI’s target of 4 per cent inflation over the medium term. Without an enduring fix on food prices, monetary policy will be forced to have a disinflationary bias. Crisil has estimated that improving the supply chain infrastructure alone could reduce retail inflation in fruits and vegetables by 20 per cent. That’s where the government needs to change the game.

The writer is chief economist, Crisil

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