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RBI seen cutting interest rates by 25 bps in Feb, April – Goldman Sachs

Goldman Sachs has changed its interest rate call for India and now expects the Reserve Bank to cut key interest rates by 25bps each in February and April. It had earlier seen rates unchanged in the first half of 2015.

“The main driver of this view is our commodities team’s forecast of weak oil prices through 2Q 2015. The recent sharper than expected fall in headline inflation, contained core prices, and no sharp increase in food prices despite a weak monsoon buttress the change in our rate view,” it said.

Goldman Sachs also cut its CPI inflation forecast for the next financial year to 5.8% from 7.0% earlier.

“We do not think the RBI will launch into an even more aggressive rate cutting cycle due to entrenched inflationary expectations, uncertainty about commodity prices, and the need to establish the credibility of the new inflation targeting framework.”

CUTS AHEAD

The main reason for the change in forecast are weak oil prices seen through 2Q 2015, the firm said.

“The recent sharper than expected fall in headline inflation, contained core prices, and no sharp increase in food prices despite a weak monsoon buttress the change in our rate view. Both the trajectory and level of headline consumer prices and wholesale prices will give some comfort to the RBI.

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“The data has come in much softer than the RBI’s projections, and our new CPI forecasts suggest that inflation prints can remain below the RBI’s expected trajectory. Meanwhile, activity data has come in a bit soft, as indicated by our current activity indicator (6.9% qoq, sa, annualized in September vs 7.5% in August), and a pick-up in investment demand is taking a tad longer to materialize. Hence, the RBI should, in our view, shift focus to giving a larger weight to growth rather than a single-minded focus on inflation,” it added.

Another factor highlighted by Goldman Sachs is the weak inflation prints India has seen in recent weeks. India’s October CPI inflation came in at 5.5% yoy, 100 bps lower than the September print.

“The headline reading was below Bloomberg Consensus and our expectation of 5.7%. This was the second consecutive month that CPI was lower than expected. The moderation in the headline CPI was largely driven by food, however, fuel and core inflation also remained subdued. In sequential terms, headline CPI declined by 0.2% mom, sa after no change in September. The October WPI printed 1.8% yoy, down from 2.4% in September,” it said.

“In our near-term forecasts, we see a weak headline CPI print in November (below 5%) in part due to helpful base effects, but then a gradual increase to close to 6% by March, as helpful base effects fade away from December onwards,” it added.

For the next financial year, Goldman Sachs expects a gradual pick-up in core inflation as demand recovers, and the output gap shrinks.

“However, core inflation remains below 6% in the forecasts. Fuel inflation remains weak given our soft global oil forecasts. Food prices show a lower trajectory than in previous few years, in part due to weak global agriculture prices, second round effects of weak fuel and transportation costs, and recent government measures to lower food prices such as lower minimum support price (MSP) increases. We are therefore cutting our FY16 inflation forecast to 5.8% from 7.0% earlier. With these forecasts, we think the RBI can meet its 6% target by January 2016. Near term risks to inflation are firmly to the downside.

“Given these forecasts, and the lags in transmission, we think the RBI will start cutting rates at its policy meeting in February.”

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NO BIG CUTS HOWEVER

Goldman Sachs, however, ruled out the possibility of aggressive interest rate cuts by the RBI early next year.

“We do not, however, think that the RBI will launch into an even more aggressive rate cutting cycle due to three reasons,” it said, adding that entrenched inflation expectations, uncertainty about commodity prices and a new inflation targeting framework will keep cuts under reasonable limits.

“India’s has had an extended period of high and sticky inflation. This has led to deeply entrenched inflation expectations, which were at 13.5% in 3Q2014 for 1-year ahead. We have shown in our earlier work that inflation expectations are largely adaptive in nature. Therefore, we think a prolonged period of weak inflation would be required for expectations to come down,” it said.

Besides, it said, the recent sharp drop in commodity prices and weak food prices have been the main factors behind the sharp fall in headline inflation.

“Given the uncertainty on commodity prices, especially food, we think the RBI would be cautious about extrapolating the current trends into the future. With 48% weight in the CPI index, food prices have been subject to a large number of shocks in the recent past, and have been the principal cause of higher inflation over the past few years.”

In addition, the RBI’s new framework of de facto inflation targeting will also keep cuts limited. “While the initial target of 8% for January 2015 is not a concern, the 6% target for January 2016 has some risks. Given the need to establish the credibility of the target, in our view, the RBI would not be willing to risk compromising it through a period of aggressive easing,” it said.

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