Will RBI cave-in to govt pressure and cut interest rates despite inflation concerns?

Key highlights:

• RBI will on Wednesday announced its bi-monthly monetary policy review at 02:30 pm
• Government is seeking the lowering of interest rates in order to boost the economy
• RBI is expected to keep the interest rates unchanged today due to the sharp rise in inflation

All eyes are on the Reserve Bank of India (RBI) Governor Urjit Patel on what decision he and the Monetary Policy Committee (MPC) would take during the bank's October bi-monthly monetary policy. 

Many economists expect the RBI to keep interest rates unchanged due to the sharp rise in inflation the last few months.

Consumer inflation surged to a five-month high in August to 3.36% as against 2.36% in July. This is an an almost 182 basis points increase in two months. This is a threat to RBI's target of maintaining it at around 4%, the mid-point of its mandated target of of between 2 to 6%.

Besides this, core inflation, which excludes food and energy, has grown even higher as it has reached to 4.6% in August with high prices in key areas such as health and education.

WPI Inflation reached 0.9% in June 2017, increased to 1.88% in July and 3.24% in August 2017 – 246 basis points rise in last two months.

According to a SBI report, the RBI is likely to maintain status quo on key lending rate in its October 4 policy decision as it is "stuck in a conundrum" of low growth, mild inflation and global uncertainties.

It said that against the background of flexible inflation targeting, the obvious question that arises is choosing between the move towards the 4% inflation target swiftly or staying in the inflation band.

Ashutosh Datar and Amit Tiwari, analysts at IIFL said, "Although the uptick in July was along expected lines, the uptick in August is a bit disconcerting, given that it has been driven by higher core inflation. The risks have increased for food inflation as well, due to an indifferent monsoon in many parts of the country and slightly lower Kharif acreage.”

Anjali Verma, analyst, Phillip Capital said, "Inflation is expected to trend higher from the current levels owing to unfavourable base effect and possible commodity inflation. Expected range for CPI for rest‐FY18 is at 3.8%‐4.5%, which at best is in line with RBI’s estimates. No positive surprise, means no scope for rate reduction, assuming that RBI’s core objective remains inflation targeting (and not boosting growth). Thus, we maintain that RBI will stay on hold for the rest of FY18."

On the other hand, the government has been coming under immense pressure as the GDP growth has taken a big hit due to the impact of demonetisation and the Goods and Service Tax (GST).

A top finance ministry official last week was reported saying there is scope for an RBI rate cut at the next policy review as retail inflation continues to be low.

It is not only the government but also various industry bodies that have written to the RBI to reduce the interest rates in order to boost growth amid the slowdown in the economy.

Assocham has written to the RBI and the MPC to cut the interest rates at least by 25 basis points, given the challenges being faced by the economy which needs immediate measures for revival of growth.

Even the Confederation of Indian Industry (CII) has called for a reduction in interest rates of 100 basis points to boost the economic growth rate.

However, some analysts still feel that that despite the high inflation there is still room for a 25 basis point cut.

Kapil Gupta, Prateek Parekh and Akshay Gattani, analysts at Edelweiss Financial Services said, "We foresee inflation moving towards 4% in the next couple of months and 4.5% by the year end. This implies FY18 inflation will range from 3.5-4.0%, within RBI’s comfort zone. This certainly opens room for further rate cuts. Our base case is another 25bps cut in FY18, but we strongly believe that more is warranted."

Another concern for RBI is that the government will increase its spending to boost growth. This will potentially impact the current fiscal deficit target of 3.2% of the GDP for year ending March.

The RBI also has its eyes on the uncertainty of the US Federal Reserve as it starts its massive monetary stimulus later during the year and gradually increases US interest rates.

Added to this is the concern of a weak rupee which is a cause for concern for the RBI about its impact on market stability and raising import inflation.

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