RBI in its annual report clearly acknowledged the possibility of demand and growth revival on the back of reflationary fiscal approach which will boost consumption demand even as outlook for investments and external demand remain uncertain. Associated with this outlook and higher international commodity prices, risks to inflation is on the higher side. These will negate the impact of better monsoon in food inflation. Our read though is that under such a scenario, RBI’s ability to continue on the path of aggressive OMO purchase of Gsec will diminish.
The RBI has frontloaded the OMO purchase in H1FY17 to create sufficient liquidity ahead of the FCNRB redemptions in Sep-Nov’16, implying lower pace of OMO purchases in H2FY17. Higher inflation, improved credit demand and slower pace of OMO purchase will harden Gsec yields going forward, thereby limiting RBI’s ability to generate earning surplus.
Stimulus led growth in FY17
The report has indicated that the 7th pay commission award is a stimulus to consumption spending within the targeted ﬁscal deﬁcit through the multiplier effects of government consumption expenditure. While a durable pick-up in investment activity remains distant, consumption will continue to be a main driver to growth with boost from the revival of rural demand in response to the above-normal southwest monsoon as well as from the 7th pay commission. No strong triggers are discernible at this juncture that could engineer a turnaround in industrial activity. Going forward, the improvement expected in agricultural activity could reverse deterioration in consumer non-durables and boost rural incomes. Successive downgrades of global growth projections by multilateral agencies and the continuing sluggishness in world trade points to further slackening of external demand going forward. Service sector activity is likely to receive a stimulus especially under the category of community & social spending sector growth. Overall GVA growth is, therefore, projected at 7.6% in FY17, up from 7.2% last year.
Upside risks emanating for Inflation
Report highlighted the possible uptick in global commodity prices, closing of output gap and 7th pay commission impact is likely to offset the benefit of possible ease in food inflation. The impact of the implementation of the 7th pay commission on overall CPI are expected to emanate from increased house rent allowance in the CPI. In addition, indirect effects through demand and expectations channels could add to the headline CPI’s path. In aggregate, the impact of the pay commission is expected to peak by Sep’17. The impact of GST on CPI inﬂation would largely depend on the standard rate that would be decided by the GST council; however, the impact is likely to be low, with around 54% of the CPI basket exempt from the GST.