Was there an actual fall in inflation?

The sharp fall in inflation in recent months had largely convinced everyone on the direction of monetary policy. The question was when and how much.

In our view, inflation is set to undershoot the Reserve Bank of India’s January 2016 target of 6 per cent.

Rural wage growth has fallen to mid-single digits, which along with a negative output gap, low commodity prices, tight monetary policy and low increase in minimum support prices should ensure continued disinflation.

We expect Consumer Price Index-based inflation to hover around 5.5 per cent in 2015, undershooting the central bank’s 6 per cent target by about 50 basis points.

Inflation undershoot will open up the space for rate cuts.

RBI has pointed to the next Budget as an important milestone, indicating a status quo at the next policy on February 3.

We expect a 25-bp rate cut each in April and June, and repo rates to remain on hold at 7.50 per cent thereafter.

Rate cuts are unlikely to be aggressive, in our view.

According to RBI, the government has largely agreed to the Urjit Patel Committee recommendation of a medium-term CPI target of 4 +/-2 per cent.

With potential growth having fallen to around 6 per cent and growth likely to gradually pick up in 2015-16, the output gap will gradually close.

This is important because while there are structural reasons why CPI-based inflation is lower, it is also partly cyclical, and as the output gap closes, the pace of disinflation will slow down.

Hence, RBI's stance has to be guided not just by the near-term undershoot on inflation, but the optimal policy stance, which will stabilise inflation around 4-6 per cent even as the growth cycle starts to recover.

Our estimates suggest that repo rate at around 7.50 per cent is consistent with stabilising inflation around 5 per cent.

If RBI cuts more or lesser than this, then medium-term inflation will be higher or lower.

Sonal Varma
Executive Director & India Economist, Nomura Financial Advisory & Securities India Pvt Ltd