The upside risks to inflation remains, with higher inflation of 5.0% expected in H2FY18. Accordingly, RBI maintains its real GVA growth estimate at 7.4% in FY18E from 6.9% in FY17E which is to be accompanied by increase in base case inflation from current 3.7% to 5% by end of FY18. Underlying policy print, implied more hawkishness as compared to previous policy, however the factors likely monsoon, MSP prices, government policies and GST is likely to determine change in stance. In this context, and with hardening of global yields, Indian Gsec yields is likely to harden.
Inflationary pressure to re-emerge along with higher growth
MPC clearly spells out higher upside risks to inflation. Average CPI is projected to be higher at 4.5% in H1FY18, currently at 3.7% in Feb’17, to 5.0% in H2FY18. Currently, demonetization spillovers has suppressed the headline inflation numbers. Headline inflation is likely to edge higher as the temporary impact of demonetization on perishable food items fades out initially and core inflation, currently ~5%, also inch up along with cyclical upswing in demand. The factors that are expected to reinforce inflationary pressure include a) Deficient south west monsoon and higher MSPs reinforcing food inflation, b) increase in HRA as recommended by 7th pay commission is likely to push baseline inflation trajectory by 100-150bps, c) initial effect from implementation of GST, d) farm loan waivers by state governments, e) policy focus to revive demand particularly from increase in budget allocation towards rural & affordable housing, f) narrowing of output gap as remonetisation progresses, g) spillover of improving global prospects on commodity prices, h) rising inflation in advance economies due to reflationary policies, i) currency impact arising from normalization of monetary policy in advance economies, especially US Fed and j) protectionism policies adopted across the world which further adds to the inflationary pressures.
On growth front (real GVA), the outlook is seen favorable at 7.4% vs 6.7% on the back of a) gaining remonetisation, b) reflationary fiscal policies, specially targeted towards rural demand and c) cyclical upturn in global growth.
Excess liquidity seen as transient, RBI to use mix of conventional tools
Overall excess liquidity in the system is ~INR4.4tn i.e. 3.8% of NDTL. However, RBI appears to have taken a view that this excess liquidity is transient. In our view, this liquidity will dissipate by end of Q1FY18 on the back of continued remonetisation and normalization of credit growth, which has declined to 4.3%, a 60 year low. As per our estimates, from currently levels an additional Rs 4.8tn worth of currency notes is required to equalize levels prior to demonetization and Rs 5.5 tn to also meet the normalized currency demand by Jul’ 2017. To manage the transient excess liquidity, RBI is likely to use a mix of its conventional tools such as a) Variable reverse repo transactions for longer maturity, b) MSS operations and c) standing deposit facility after government approval.