Markets price in more easing by Indian central bank, see risk in policy shift

October 5, 2016 8:11 AM EDT

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By Suvashree Choudhury and Rafael Nam

MUMBAI (Reuters) - The Reserve Bank of India has embarked on a significant but potentially risky shift towards greater tolerance of higher inflation under new governor Urjit Patel, prompting markets to price in another rate cut.

On Tuesday, Patel and the newly formed monetary policy panel cut the policy rate by 25 basis points and softened the RBI's stance on the timeline for meeting its inflation target, indicating that it had until 2021 to reach it.

And by lowering its real interest rate target to 1.25 percent, from the 1.5-2 percent band set by Patel's predecessor Raghuram Rajan, the RBI gave itself more room to cut rates further.

The moves sent the benchmark 10-year bond yield down to a more than 7-year low on Wednesday, on expectations of another rate cut, either in December or February.

But some economists worry that a shift from Rajan's more cautious stance could backfire should it raise doubts in the market about the bank's management of prices, particularly while global investors are getting used to Patel's leadership.

"The RBI has put its credibility on the line, one that was built up in the three years prior to this under Rajan," said Shilan Shah, an economist with Capital Economics.

"There's now an increased chance the RBI will have to reverse course over the next 12-18 months if inflation suddenly increases, which would be quite damaging."

Rajan and his then deputy Patel fought hard for a consumer inflation target of 2 to 6 percent to anchor expectations in a country with a history of volatile prices.

Having convinced the government to agree to it in 2015, Rajan set an aggressive goal to gradually bring inflation down to 4 percent by March 2018. The target was written into law this year.

The stance earned him rebukes from within government and big business, because critics said the goal placed too much of a constraint on economic growth.

GLOBAL TREND

An official familiar with the RBI's thinking said Patel's stance better reflected the flexibility provided by the government's wide-ranging target, one that had been intended to also focus on economic growth.

Though India remains one of the world's fastest-growing major economies, its 7.1 percent expansion in the April-June quarter from a year earlier is below the 8 percent needed to sustain full employment.

The official added that ultra-low interest rates globally justified an easier policy stance, with India's real interest rates now standing at around 1.25 percent.

"Globally, the majority of the countries are seeing huge deceleration in inflation, and in fact are below their inflation targets. We should also therefore have a lower neutral rate than before," said the source.

Rajan's relentless push against inflation was widely seen as a game-changer in a country where consumer prices were rising more than 10 percent as recently as 2013.

Now, Patel and his panel, which backed him unanimously, are betting inflation will ease further after hitting a five-month low of 5.05 percent in August after strong monsoon rains pushed food prices lower.

For some that marks a bold assumption at a time when the government has just raised the salaries of millions of employees and pensioners and is gearing up to debut a national goods and services tax that is expected to increase prices.

Nomura said it now expected the RBI to cut rates once more by February, but questioned whether it was justified.

"We do not believe that easing is justified on economic grounds, as inflation expectations have risen, core inflation is still sticky and there are upside risks to inflation next year."

Uncertainty over the RBI's decision may be amplified by Patel's preference to shun the limelight, which could make it harder to get a clear read of the bank's policy stance.

His news briefing on Tuesday was his first public speech since his appointment by the government in August. It lasted around 15 minutes compared with Rajan's press conferences that would typically last 45 minutes.

(Editing by Mike Collett-White)



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