With CPI inflation at over 5 year high, forget a rate cut from RBI in the next policy

The retail inflation for December, at 7.35 percent, the highest in a little over five years, will likely prompt the Reserve Bank of India (RBI) rethink future rate actions, say economists and analysts. While a rate cut in the next policy is ruled out, the central bank may stay on hold till clarity emerges, they said. This is for the first time since July, 2016, the Consumer Price Index (CPI) inflation is breaching the 2 percent -6 percent inflation band set for the RBI by the government. In July, 2016, the CPI was recorded at 6.07 percent.

RBI may stay on hold

The higher-than-expected inflation immediately puts the central bank on a cautious path. While it may not hike rate in the next RBI policy, a rate cut that should have ideally come in the backdrop of constantly slowing economy too looks unlikely now. The RBI and the monetary policy committee (MPC) will watch for the next few months before taking a call on the stance, economists said. If the CPI continues to stay high, the RBI may stay on hold for rest of the year.

“Given this number, next few months CPI expected to firm up further. For the headline to converge to 4 percent over the next fiscal year, food inflation will need to reverse dramatically. We maintain our no rate cut until October- December quarter 2020,” said Shubhada Rao, Chief Economist, at Yes bank.

The new RBI stance will be logically bad news for the government that would want further rate cuts to aid growth recovery. The government, as such, is a tough spot on account of a revenue shortfall that has severely curtailed its ability to keep up the public spending. The GDP growth for the full fiscal year is expected to come at 5 percent, while many economists are debating whether the final number will be even lower.

Core inflation sticky

Secondly, the fact to note is that in December, the core inflation (excluding volatile food and fuel components), too has inched up a bit. The core inflation, at 3.54 percent, is the highest since September last year. A sticky core inflation would further add to the worry of the central bank. This is because food and fuel prices typically fluctuate and may change month to month but core inflation indicates the broader trajectory.

According to Aditi Nayar, Principal Economist at Icra, the revision in rail fares, uptick in prices of some categories of automobiles as well as an unfavourable base effect, may contribute to a further uptick in the core inflation to around 4.0 percent in the ongoing month.

The RBI has cut policy rate by a total of 135 basis points in the current rate cut cycle. The central bank is also looking at the fiscal scenario. If the government breaches the fiscal deficit target, which is a possibility in the present scenario, the RBI will have one more reason to continue with its cautious policy stance.

What does it mean for banks?

If RBI turns  to a pause mode from this point and changes stance to ‘neutral’ from ‘accommodative’, that would mean bond yields may harden impacting the treasury portfolios of banks starting the fourth quarter, said Siddarth Purohit, analyst at SMC Global Securities.

“Since interest rates are not the key reason that is driving the credit growth or lack of it but low demand, a rate pause may not have much impact on lending patterns. But, if yields harden, it could start hitting banks’ treasury earnings in the fourth quarter,” Purohit said.

The ongoing US-Iran tension could keep the fuel price at an elevated level, which could impact domestic inflation even if the food prices ease. Yield on 10-year G-Secs had eased about 20 basis points in the aftermath of the ‘Operation Twist’ by the RBI but the developments in the middle-east had caused a spike. Treasury income is a key contributor to a bank’s earnings.

Indian banks have been struggling with subdued credit growth due to slackened demand. According to rating agency, Icra, banks’ credit growth may plunge to a six-decade low of 6.5-7 per cent in FY20.