RBI expected to cut policy rates next month as India stands to benefit from falling oil prices

India’s benchmark CPI inflation rose at a slower-than-expected pace in December 2014 at 5.0% y/y (Consensus: 5.3%), after easing to 8 year low of 4.4% in the previous month. The pick-up was mainly led by an unfavorable base effect and higher food inflation. Reassuringly, core CPI inflation corrected further to 5.2% y/y (5.5% previously), reflecting weak consumer purchasing power; and underscores our expectations of a 25 bps policy rate cut at RBI’s next meeting on 3rd February. Looking ahead, assuming oil prices remain stable, we project headline CPI inflation to average 6.0% y/y in 2015 from 7.2% y/y last year. Risks to inflation are broadly balanced, on the upside by - existing wage rigidities and an unfavorable base effect; and on the downside by - well anchored inflation expectations, a benign commodity price outlook and the government’s efforts to ease domestic supply side bottlenecks across food and energy. As a net oil importer, India stands to benefit from the sharp fall global crude oil prices. We expect the near 50% fall in international oil prices since June 2014 to – 1) foster a benign inflation environment in India, 2) lift real incomes of households, 3) reduce input costs for domestic industry, in turn abetting profitability and investments, 4) aid external balance (about 31% of India’s total imports are oil imports), 5) provide scope for the government to augment fiscal space through energy subsidy reforms, in turn boosting productive spending; and 6) enhance room for RBI to exercise growth supportive rate cuts. Our estimation of India’s trade balance sensitivity to falling crude oil prices suggests a 0.46 percentage point improvement in India’s trade balance (as a percent of GDP) following a 10% fall in the price of Brent crude.

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