A calm rupee has been the cornerstone of India’s macroeconomic stability in the past three years. Since its steep fall following the US Fed chairman’s ‘taper’ remark in 2013, the currency has barely wobbled. This also coincides with adoption of the popular inflation targeting framework for monetary policy in 2014. In this period, the rupee has been just about as volatile on average as it was when the exchange rate regime was a ‘managed float’ (see accompanying graphic). Indeed, after 2009-10, when India shifted to a floating exchange rate, the rupee was much more volatile than has been the case under flexible inflation targeting. No doubt, this drop in rupee variability is due to far heavier exchange rate management than ever before. Deviating from past intervention patterns—mostly one-sided buying of excess capital inflow—RBI now regularly intervenes in both directions, i.e., purchases and sales, since 2014; in the past, foreign currency sales mostly coincided with external shocks such as the 2008 crisis, US downgrade/Eurozone crisis (2011-12) and ‘taper-tantrum’ (2013) to limit volatility and manage orderly depreciations. There have been no external pressures on these scales since. RBI’s iron grip over rupee movements in the inflation-targeting period has been enormously helped by a favourable, nay divine, confluence of external factors. The collapse in international oil and commodity prices from late-2014, to start with. This reduced monthly import payment pressures but more than that it significantly contributed towards lower inflation, fiscal improvements and a narrower current account deficit. More to the point, the narrowed domestic-foreign inflation differentials allowed RBI to let the rupee strengthen with occasional, small corrections in line with its inflation targets. Global liquidity remained abundant with the combined onslaught of quantitative easing (QE) by three of the developed-world central banks, the US Federal Reserve, European Central Bank (ECB) and Bank of Japan (BOJ). The simultaneous buoyancy of capital inflows yielded large capital account surpluses, which muted the drought in export earnings. Foreign currency markets in other parts of the world remained exceptionally tranquil as well. Fortune smiled even more by a complete absence of external shocks of severity and magnitudes seen in 2008 and 2013.
However, these dynamics have either reversed or will begin to do so in 2018. Some, like oil and metal prices have already turned up while others such as advanced countries’ monetary policies are set to normalise ahead. Although the BOJ is staying its monetary stimulus course for now, the US Fed has gradually started shrinking its balance sheet, increased its policy rate three times this year and forecast as many rate hikes next year followed by two more in 2019; the ECB is not going to increase its bond buying for sure and looking at an eventual retreat. The global monetary environment is tightening, the augurs for a stronger dollar appear positive. And many predict financial volatility from China and other readjustments in 2018. These changes affect Indian inflation, capital flows, external and internal accounts, while global financial shocks are destabilising. All of these bear upon the key price in the economy, or the exchange rate. The return of cost-push pressures has already moved inflation concerns to the macro-centrestage. With higher input prices steadily feeding through to domestic producers, it’s a matter of time before they pass these on. In the forthcoming months, RBI’s inflation forecast errors may lie on the upside, i.e., underestimate actual inflation outturn, in contrast to its over predictions of inflation in past months. The benchmark ten-year bond yield hasn’t stopped climbing for more than a month now. This isn’t merely because of rising inflation premium but also because investors sense the escalating risk of fiscal slippages—the oil revenue windfall is now past, falling tax collections are the new worry. The current account has already begun to widen notwithstanding the uptick in exports. For RBI, which was able to fine tune exchange rate movements so far to keep the rupee stable, the course ahead is unlikely to be as smooth in these changed circumstances. Higher inflation and rising yields at a time of weak growth make exchange rate management that much more difficult. It is harder if capital inflows moderate and the central bank must mind the current account gap. And when capital inflows are plentiful, monetary management is even more complicated because adjustments to appreciation pressures come with the risk of exchange rate misalignment, threat of eventual, abrupt corrections to past overvaluations should capital flows suddenly reverse on changed sentiments, fears and risk appetite of foreign investors. Either way, the battle between achieving the inflation target and exchange rate stability appears toughening in 2018. A more constrained RBI due to the increasingly unfavourable combination of macro factors may have to accept greater exchange rate flexibility than it has in 2014-17. This would allow some autonomy in monetary policy and serve to adjust the economy to external shocks. But this is often accompanied by acute swings in the exchange rate, especially where emerging market currencies are concerned. Sharp fluctuations of the exchange rate have significant effects upon the real economy, domestic prices and the financial sector. While the new monetary framework is as yet untested on these aspects, the changing landscape suggests RBI may not be able to maintain the rupee’s exceptional stability as before. It may have to tolerate more disruptive volatility.