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RBI latest meeting 'diluted' its old policy framework: Nomura

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The Reserve Bank of India's (RBI) monetary policy announcement may indicate the central bank will water down its previous inflation-targeting framework, according to Nomura analysts.

On Tuesday, the central bank surprised the market with a 25-basis-point cut to its policy repo rate, or the rate at which it lends to banks, to 6.25 percent.

It set its medium-term inflation target at 4 percent, within a band of plus or minus 2 percent, but maintained the 5 percent target by March 2017.

The target for the real neutral interest rate, or the rate at which the economy is growing at its trend rate with stable inflation, was also lowered to 1.25 percent on the back of lower global rates, from an earlier range of 1.5 to 2 percent.

"We believe that there has been a dilution of the tenets of flexible inflation targeting framework under the new regime compared with the old regime," said Nomura analysts Sonal Varma and Neha Saraf in a Tuesday note.

They noted that under the old regime, led by former Governor Raghuram Rajan, the RBI was clear about lowering inflation to 4 percent by March 2018 and keeping it there. The new medium term target was "too wide a range, without a specific time commitment to the midpoint."

Consumer price inflation in India eased to 5.05 percent on-year in August, compared with July's 6.07 percent, on the back of slower rises in food prices. Wholesale prices were up 3.74 percent on-year, a touch higher than July's reading of 3.55 percent, but below market expectations.

Analysts, however, pointed out most of the growth drivers were consumption-oriented, which could put pressure on prices in the future.

For the real rate target, Varma and Saraf said they were not sure about the "sanctity of the new number," and with global rates near zero, they expected it to be lowered further.

The makeup of the RBI's decision-making has also changed: This was the first meeting with a six-member Monetary Policy Committee (MPC), which was led by new Governor Urjit Patel.

The MPC effectively gives the government a voice in central bank decision-making through three appointed external members. Previously, the central bank governor alone made policy decisions.

On Tuesday, all six members voted to lower the repo rate.

The RBI said it expected India's growth momentum to quicken, with a normal monsoon season expected to raise agricultural growth and rural demand, while plans to raise government employee salaries would provide stimulus to urban consumption spending.

Strong improvements in farming practices were expected to improve the food inflation outlook, the central bank added.

Earlier this year, the Indian government followed recommendations from the Seventh Pay Commission's recommendations and announced a 23.55 percent hike in salaries and pensions for nearly 10 million current and former government employees, reported Reuters.

Need for collaboration with the government

Radhika Rao, an economist at Singapore's DBS Bank, said the MPC would find it challenging to keep to their inflation target in fiscal 2017-18 and would need to work closely with the government to keep prices stable.

That's in part because the 4 percent inflation target implicitly held the RBI responsible for the direction of food prices, which is the largest component of the consumer price index (CPI) basket, according to Rao.

In order to bring down overall inflation, food prices needed to be under control.

They were, however, dependent on things outside the RBI's influence: the weather, seasons and the infrastructure in place to ensure the delivery of agricultural produce from farms to the homes of consumers.

"As we witnessed in the past three years, the RBI had little direct control over the price increases of cereal in fiscal 2011-12, vegetables in fiscal 2012-13 and pulses [legumes] last year," she said, adding this was where the RBI needed government support to keep food prices under control.

The government had been working to keep inflation stable by removing diesel subsidies, modestly raising the prices at which it buys crops from farmers and implementing administrative measures to curb hoarding and other malpractices that intentionally keep food supply low, Rao said in a Tuesday note.

For example, in late 2015, local media reported nearly 75,000 tons of legumes were seized from hoarders in as many as 13 states.

She also pointed out several other obstacles to the RBI's medium-term inflation target: higher aggregate demand next year due to a normal monsoon, salary increases from the Seventh Pay Commission's recommendations and steady-to-higher food prices from structural inadequacies caused by uneven rainfall throughout the country during the monsoon season.

Depending on how much rain a particular region receives, different crops would be affected. Rao explained the current infrastructure was not up to par to tackle a supply shortage in any particular crop, which tends to drive food prices higher.

The implementation of the goods and services tax (GST) was also expected to temporarily boost price pressures.

"We expect the GST implementation to result in a 20 to 70 basis-point increase in headline inflation as we expect asymmetric pricing behavior by firms," added Nomura's Varma and Saraf.

That meant firms were expected to pass on the service tax increase to consumers, but would absorb lower manufacturing taxes in their margins.

But while these inflation pressures may make hitting the longer-term inflation target difficult, in the shorter term, there were signs that inflation could ease.

Most analysts now expected the RBI to lower rates by another 25 basis points by March 2017, but some said it might make more sense to cut rates at its next meeting in December as near-term inflation was likely to have moderated further in September.

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