Could an inflation spike rain on india’s parade?

Last week’s rate cut has been cheered, but the monsoon’s effect on food prices has clouded the outlook

Monsoons has been above average this year, causing floods in some states such as Kolkata, pictured. But crop sowing has decelerated. Dibyangshu SARKAR/AFP

Indian business leaders have been cheering the latest interest rate cut by the country's central bank, as they widely expect it to boost economic growth.

On Wednesday, the Reserve Bank of India (RBI) cut the key interest rate to 6 per cent from 6.25 per cent – a six and a half year low.

But as reality sets in, analysts warn that there are still inflationary risks on the horizon and that it takes more than a rate cut to keep propelling the Indian economy.

"Headline inflation bottomed in June and we expect it to rise gradually to above the medium-term target of 4 per cent on higher food prices and [other] factors," says Neha Saraf, the India economist at Nomura.

Inflation has been hitting record lows in India, helped by easing food and fuel prices. The latest figures, for June, showed a decline to a record low of 1.5 per cent year-on-year.

Lower inflation generally gives central banks the scope to cut interest rates, which in turn makes loans cheaper. If inflation is uncomfortably high, a rate cut risks pushing prices of goods even higher by creating more demand through cheaper lending.

Rate cuts also generally help to spur economic growth because cheaper loans help companies to expand and make borrowing more affordable for consumers, for example, in the case of car and home loans.

However, there are several factors that could push inflation higher, analysts say.

For example, on July 1, India introduced a new goods and services tax (GST) to streamline the  taxation system across the country.

"Coming to areas where inflation may appear, it is important to understand that though GST implementation in India initially has had little impact on reported prices, it's too early to assume that there will be no impact," says Anil Rego, the chief executive and founder of Right Horizons, an investment advisory based in Bangalore. "It's just been a month, and hence we should wait for some more time to see the effects of GST implementation on inflation."

Also the ongoing monsoon rains could still wreak havoc.

"While rainfall in the ongoing Indian monsoon season has been largely tracking above normal, crop sowing data as of July 21, showed deceleration compared to the previous week," Mr Rego says. "If this does not pick up pace, there can be an impact on food inflation. Globally food prices have been inching up recently amid reports of climate issues impacting yields. This could have the potential to transmit to India."

The recent spike in tomato prices in India, which have become a much-talked about topic and an area of concern for India's poor, illustrates how volatile food prices can be.

Several state governments, including of Maharashtra and Uttar Pradesh, recently unveiled costly stimulus programmes to waive farm loans to help small farmers struggling under debt burdens, and the RBI highlighted that this could feed into inflation.

Meanwhile, the RBI has stressed that a rate cut alone is not enough to boost India's economy.

"The current state of the economy underscores the need to revive private investment, restore banking sector health and remove infrastructural bottlenecks," RBI said at its latest policy meeting, highlighting the "urgent need" for the government to take action on such areas. "Monetary policy can play a more effective role only when these factors are in place."

But the latest interest rate cut  certainly comes as a welcome relief for India's government.

While inflation eased, tensions surged between the government and the RBI, after the central bank opted to keeps interest rates on hold at the previous monetary policy meeting in June.

The RBI governor, Urjit Patel, at that time cited risks to inflation as the reason behind the decision, including "rising rural wages, robust consumption demand" and the possibility of "imported inflation" cased by global risks, as it waited "for greater clarity to emerge with incoming data".

He also said that a meeting called by the Indian finance ministry did not take place because "all the monetary policy committee members declined the request of the finance ministry for that meeting".

Arun Jaitley, India's finance minister, had been calling for a rate cut before the June meeting.

How autonomous India's central bank is of the government often is a matter of debate. The Indian prime minister Narendra Modi's demonetisation move to ban the two highest value banknotes in November in particular brought the RBI's independence into question.

The RBI's move in June to not cut rates and the revelation that it had not entertained the meeting, was perceived as a show of strength by the central bank.

Notably, analysts point out that the RBI's policy stance remains unchanged, despite the fact that it trimmed rate on Wednesday.

"An important point to note is that the RBI has not changed the policy stance, which continues to be neutral," says VK Vijayakumar,  the chief investment strategist at Geojit Financial Services. "A shift to an accommodative stance would have been better from the sentiments perspective. To that extent, the decision is disappointing. It is important to note that India has the second highest real interest rate in Asia presently. This is detrimental to credit expansion and economic growth."

Srividya Kannan, the director of Avaali Solutions based in Bangalore, says there are number of factors that could hold the economy back.

"The impact on lending may still not be as much given the tough learnings from the past relating to bad loans," she says.

"The level of scrutiny in banks relating to unworthy borrowers is only increasing and rightfully so. Manufacturing sector will take some time to build momentum from the after effects of GST and demonetisation."

Meanwhile, Non-Resident Indians (NRs) could be among the beneficiaries of the RBI's latest move.

"For NRIs who are new to Indian real estate investment, a rate cut will obviously coax them to consider investing in property, " says Mr Rego.

"Locking in a lower loan interest rate will help buy homes across key cities and boost chances of getting good returns later because total acquisition cost becomes lower."

But he also points out that history shows that rate cuts take time to be passed on to borrowers and that savers will be at a disadvantage as the rates on their savings accounts go down.

Such lowering of deposit rates will reduce the incentive for NRIs who have taken out loans in the UAE at relatively low interest rates and then placed it in fixed "deposits in India carrying relatively higher rates of interest".

Manoj Paliwal, the chief financial officer of Omkar Realtors and Developers, one of Mumbai biggest property developers, is upbeat on the RBI's move.

"The rate cut will pump in much needed confidence in the real estate sector due to softening of interest rates which have been stable for quite some time now," he says.