India Insight:Benign inflation opens up scope for further policy easing

Headline CPI inflation decelerates further to 4.2%YoY in October, lowestin 13 months: This compares with 4.4%YoY registered in the previousmonth. This was slightly above our expectation of 4.1%YoY. Core inflationremained largely stable at 4.9%YoY in October compared to the previousmonth. See detailed discussion on the next page.

CPI inflation to remain manageable: We believe a favourable base effectwill help keep CPI inflation around the 4-4.2% range in November before itstarts to rise again. We expect CPI inflation to average 4.6%YoY duringthe months of December 2016 to March 2017 (lower than the RBI’s targetof 5% for Mar-17). The bumper summer crop (food grain production up 9%YoY as per first advance estimates), good progress in the sowing of wintercrops, a deferred hike in allowances under the 7th Pay Commission, sluggishglobal crude oil prices and a gradual domestic demand recovery will likelykeep inflationary pressures contained over the coming months, in our view.

Even the impact of GST (implementation likely next year) on inflation isexpected to be minimal in the short term, with 50% of the CPI basket keptoutside of the GST purview. In addition, we believe the recent policy initiativetowards demonetisation (link) will be disinflationary, as this should result inslowdown in economic activity over the next couple of quarters and wealtherosion. Indeed, we see 30-50bps downside risks to our FY17 GVAgrowth forecasts of 7.4%YoY on recent demonetisation measures.

Policy implication: We believe the stance of monetary policy remainsaccommodative and see scope of further 50-75bps cut in the repo rateover the next 12-months. In the last policy review, RBI had indicated thatreal neutral interest rates (measured as 1-year T-bill yield less expected CPIinflation) could be lowered to 125bps (vs. 150-200bps earlier). With CPIinflation expected to remain manageable (4.5% average estimated over thenext 12-months assuming no weather related distortion), this will open upspace for more policy easing, in our view. While we see a higher probability ofa next rate cut in December, the timing (Dec or Feb) is still debatable at thispoint considering the next MPC meeting is scheduled on December 6-7, aweek before the FOMC meeting on Dec 13-14.

Will possible Fed hike be a spoilsport? There is a concern that a possible25bps increase in interest rates by the Fed in Dec-16 will lead to risk aversionin EMs and capital outflows. This will weigh on RBI’s decision to cut policyrates around the time when Fed is hiking. That said, our global economicsteam expects the spillover impact of a Fed hike to be short-lived and muted(link). Indeed, post the 25bps hike in Dec, our US economist expects acontinuation of the Fed’s “slow and cautious” policy and, on average, 50bpsper year until the upper end of the Fed Funds range reaches our forecastterminal level of 2% in mid-2019. We believe India, with a stable externalposition including a contained current account deficit, adequate foreignexchange reserves, favourable FDI trends and reform progress, will be able towithstand volatility without significant pressure on the currency (USD/INR).