The run-up to the sixth bi-monthly monetary policy review by RBI’s Monetary Policy Committee was laced with several unfavourable developments. Since the last policy review in December 2017, price for India Crude Basket firmed up by ~8% while 10Y US Treasury yield spiked by 43 bps. More importantly, there was fructification of fiscal slippage risks with the recent budgetary announcements highlighting a delay to the proposed fiscal consolidation roadmap as enumerated by the FRBM Committee report. The unfolding of these factors resulted in domestic rates market pricing in about 50 bps rate hike within the next one year along with a drift in monetary policy tone towards hawkish.
In contrast to rising nervousness in domestic rates market, the RBI maintained status quo in February2018 monetary policy review and buttressed it further by accentuating its erstwhile neutral stance. However, the February monetary policy outcome can be construed as hawkish by few market participants. After all, the central bank raised its Q4 FY18 inflation estimate to 5.1% from 4.7% provided earlier in December 2017. More importantly, for the first time in MPC’s history, one out of six members voted explicitly in favour of a 25 bps rate hike.
Nevertheless, bond markets posted a moderate rally after the policy announcement with 10-year government security yield declining by 4 bps towards the end of trading hours. So how does one explain this outcome? In my opinion, the monetary policy tone and communication has important takeaways. For the first time, the RBI policy introduced its projected inflation trajectory for FY19. While it talks about further acceleration in inflation to 5.1-5.6% range in H1 FY19 from 5.1% in Q4 FY18, it also highlights a move lower towards 4.5-4.6% in H2 FY19. This has two important implications: Inflation concerns would peak out in the short term (H1 FY19) before making a strong retracement towards the medium term target of 4% in H2 FY19. Inflation, one year ahead, is projected to be lower vis-à-vis current levels.
Second, while the central bank added fisc as a potential source of upside risk to inflation, especially, the proposed budgetary dispensation towards setting up of Minimum Support Prices for the upcoming kharif sowing season in 2018, it also enumerated risk mitigants in the form of subdued capacity utilisation, recent stabilisation in crude oil prices, and moderation in real rural wage growth. In my opinion, there is considerable uncertainty with respect to the budgetary announcement on recalibration of MSPs to 1.5 times the cost of production. Choice of A2 (Actual paid out cost including rent paid for leased-in land) or A2+FL (A2+ imputed value of family labour) benchmarks for cost of production as prescribed by the CACP could dampen the feared inflationary impact. This impact could be further muted if the government decides to recalibrate rabi MSPs, which are already running higher than A2+FL benchmarks, thereby providing some cushion to the purported price adjustments. Amidst this uncertainty on MSP recalibration, including the choice of crop, it was prudent to take a non-committal and neutral stance and await clarity.
While the RBI expects economic growth to recover in FY19, it acknowledges that there is a need to nurture the fledgling recovery through conducive and stable macro-financial management. This will require an extremely nuanced and calibrated view on monetary policy rather than an abrupt change along with deployment of regulatory architecture to support growth (as the recent policy does on ensuring greater credit availability for MSMEs). The domestic rates market had turned considerably bearish by placing the cart before a flogged horse. By outlining a balanced view, the RBI has made an attempt to rein in festered market sentiment while also emphasising on the need to be vigilant. This ‘look before you leap’ style of communication should hopefully curb unwarranted volatility in market sentiment.
The writer is chief economist, Yes Bank