Column: Sequencing monetary policy moves

Written by Samiran Chakraborty | Updated: Oct 28 2013, 08:50am hrs
When a central bank has to increase its inflation forecast while simultaneously reducing its growth forecast, the backdrop for a monetary policy meeting becomes complex. In its October policy meeting, the Reserve Bank of India (RBI) is likely to be faced with such a scenarioits 5.5% GDP growth forecast for FY14 is looking difficult to be achieved and the inflation trajectory has deviated upwards from the forecasted path. It is reasonable to think that RBI will be more worried about inflation as the RBI Governor, Raghuram Rajan, has indicated that there is no short-term trade-off between growth and inflation. So, markets will probably not be surprised by a 25 bps increase in the repo rate in the October policy.

Will RBI raise the repo rate by 50 bps There are two considerations that work against aggressive tightening. One, the Governor himself has recently alluded to a large negative output gap exerting disinflationary pressures with a lag. A demand slowdown is likely keeping a check on pricing power in some sectors, particularly manufactured products. A tightening shock might become an overdose; gradualism might work better. Two, a surge in food prices has caused the recent inflation pick-up. Food inflation at 18.4% in September is at a 38-month high, unusual in a year with a normal monsoon. Interest rate hikes are not a solution to food inflation, and RBI is likely to factor in the transitory nature of this food inflation.

However, regardless of the source of inflation, RBI will still be justified in stressing inflation management. There is always a risk that high food prices spill over into a more generalised inflation problem, especially when inflation expectations are still in double-digits and consumer prices (CPI) are persistently much higher than the policy rate. RBI has been worried about the consequences of keeping real rates negative for a prolonged period. To make matters worse, even core inflation started inching up in September, breaking a one-year downtrend.

In fact, going forward, the base effect on core inflation is significantly negative (in H2-FY13, the manufacturing prices index went up only 0.5%). So, even with moderate sequential month-on-month price increases, year-on-year core inflation could increase substantially. Also, suppressed inflation in fuel prices should not be ignored. At some point the government will have to narrow the gap between domestic and international prices to safeguard the fiscal deficit target. Core CPI, though a small component of the overall CPI, shows that even the services sector is experiencing considerable price pressure, despite the growth slowdown. We hope that food prices will decline; otherwise, headline inflation could turn ugly again, necessitating stronger monetary policy action.

While growth-inflation dynamics are turning unfavourable, policymakers may be breathing a sigh of relief on the external front. Fears about the inability to fund the current account deficit appear to be unfounded. With the trade gap narrowing in the last three months, we now expect the current account deficit to be halved in FY14, to 2.4% of GDP. Expectations of tapering quantitative easing in the US have been deferred, providing a window for more portfolio inflows into emerging markets like India. The scheme to bring in non-resident Indian money through a concessional swap facility has also worked well. So, the policy question has suddenly changed from What amount of FX reserves would RBI need to spend to avert a BoP crisis to When should RBI start to buy US dollars to bolster FX reserves

This improvement in the external sector has stabilised the currency markets and has given RBI the option to gradually remove some of the extraordinary liquidity tightening measures introduced earlier. The sequencing of further normalisation may be an interesting element of the October monetary policy meeting, one which could help to further steepen the yield curve. Markets are looking for three different areas of normalisationone, the corridor between the repo rate and MSF rate, which is to be brought down to 100 bps; two, liquidity easing to ensure that the overnight call rate switches from the MSF rate to the repo rate; and three, oil-marketing companies starting to access the markets for their dollar needs.

RBI has clearly indicated that the MSF rate changes would be a function of currency movements while the repo rate would be used to signal an anti-inflationary stance. So, markets would not be surprised if a 25 bps repo rate hike comes along with a 25 bps cut in the MSF rate, restoring the corridor to 100 bps.

However, the timing and method of switching the overnight rate from the MSF rate to the repo rate is unclear. In fact, the speed at which RBI will effect this change will indicate its view towards inflation and the currency. A more hawkish bias or a fear of currency depreciation may delay the switch. Even if the switch does not occur in the October policy meeting, RBI could announce a few steps towards easing liquidity. It could allow banks to borrow more under the Liquidity Adjustment Facility at the repo rate or expand the limit of the 7-day/14-day repo facility. Both these measures would reduce the effective overnight borrowing cost of the banking system gradually without causing an immediate sharp 100 bps drop in the overnight rate.

Allowing oil-marketing companies to gradually access the market for their dollar needs could happen simultaneously with the liquidity normalisation process. We expect most of the normalisation to be done during this quarter.

The menu of monetary policy instruments is quite wide in the October meeting, keeping markets guessing about the details. However, more clarity on financial reforms and the new RBI Governors market-development agenda might overshadow the importance of the monetary policy actions.

The author is managing director, and regional head of research, South Asia, Standard Chartered Bank