Most economists’ forecasts for RBI have not just been wrong, but egregiously so, for the last six months. Emboldened by an economy was thrown into reverse by the demonetisation and CPI inflation dipping below its newly-instituted 4% target, majority of forecasters six months ago expected the apex bank to trim rates by at least 50bps, possibly even by 75bps, over the coming year. By contrast, monetary policy has, in fact, evolved in consistently hawkish fashion. First, RBI refused to cut rates at its early-December review despite demonetisation. In early February, RBI not only continued to hold rates but shifted from an easing to a neutral bias.
The final nail in the rate-cut coffin then came from the minutes of the April MPC, which revealed that one of the six members, Michael Patra, flagged the need for a pre-emptive 25bps rate hike in the near future. Why have the bulk of forecasters been so ham-fisted over the last six-months? There have been three key factors; misjudgement of the impact of ‘demonetisation’, the evolving external environment and a lack of understanding of the likely implications of RBI’s newly instituted 4% inflation target. On first principles, demonetisation should not have influenced the stance of monetary policy, which notoriously operates with ‘long and variable lags’.
As the MPC appropriately argued in justifying their decision to hold policy in December, demonetisation is best seen as an inherently temporary demand shock that should not impact the medium-term inflation outlook. The only evidence of a permanent impact, for example on private sector spending behaviour or pricing intentions, should justify a policy shift. More important, as this author argued at the time, the demonetisation shock itself represented a de facto loosening of monetary policy via the tsunami of liquidity flooding the banking system. Money market, deposit rates and also corporate and sovereign bond yields all fell by around 75bps in the initial stages. Thus, the shock itself generated a partially offsetting monetary loosening.
The surge in liquidity has, in effect, significantly improved what economists term ‘transmission’: the degree of pass-through from policy rates to the key longer-term lending rates that matter most for the economy. Pass-through had, until demonetisation, been frustrating modest during the easing cycle. This changed when SBI slashed its marginal cost of funds lending rate (MCLR) by a mammoth 90bps on January 1. Other banks quickly followed. With more of RBI’s 175bps earlier cut in the repo rate now being passed onto the ‘real economy’ courtesy demonetisation, the case for more formal policy easing was further obviated.
While demonetisation has inevitably come in for plenty of criticism for the peremptory fashion in which it was introduced, it should be remembered that a permanent increase in system-wide liquidity and the lower lending rates that this would bring in its train was one of the its key aims. And it is increasingly apparent that a non-negligible portion of the surge in deposits may prove permanent. RBI data show that currency in circulation, which collapsed to a nadir of just under Rs 9 trillion from a pre-demonetisation high of around Rs 18 trillion, had still only recovered to just over Rs 14.5 trillion by the end of April.
System-wide liquidity, therefore, remains inordinately flush. Downward pressure on effective rates is, therefore, continuing, meaning that the underlying monetary impulse is still expansionary. Already this month, SBI has further cut deposit rates at various tenors by 50bps and also lowered mortgage rates for affordable housing by 25bps. The bottom line, for all the criticism, demonetisation has spurred improved transmission exactly as the policy’s architects had hoped.
The second key forecasting ‘banana skin’ has been the dramatic shift in the external environment. While the surprise election of Donald Trump helped trigger a more reflationary mindset in financial markets and pushed global interest rates up, the shift, in reality, largely reflects improved fundamentals: accelerating global growth and a smart revival in trade. A more stable Chinese economy has been key but the global upswing is increasingly synchronised with the euro-zone registering its fastest industrial momentum in over six years. In turn, the brake on the Indian economy of a contracting export sector has been suddenly lifted. The latest commerce department data shows goods exports surging at their fastest clip in six years: up 28% in the year to March. India’s export boom left in itself has not been a decisive game changer for RBI.
However, the global factors propelling it have helped to entrench the slow, but steady, interest-rate hiking cycle that the US Fed has long hankered after. Six months ago, financial markets were sceptical that the Fed would manage to hike rates even twice this year. But after rate hikes in December last year and also this March, another 25bps at the Fed’s June meeting is now also largely priced in. At least one rate hike thereafter this year, perhaps as early as September, looks increasingly likely. The backdrop of a steadily tightening Fed represents a fundamental change in the weather for RBI. Rising US rates do not automatically preclude rate cuts by emerging markets, however, they cramp policy space as relative interest rates move against the rupee.
So far, financial markets’ relative insouciance to the stepped-up pace of Fed tightening combined with the heavy portfolio inflows spurred by the UP election results has seen the rupee appreciate, not depreciate, against the dollar. But global conditions are unlikely to remain so benign nor the rupee so well supported as Fed tightening continues in June and beyond. Lastly, many forecasters seem to have misjudged the implications of RBI’s recent shift to 4% CPI inflation target (with a 2 percentage point variance either side of the central target tolerated).
The first mistake was to assume that the new six-strong MPC would, implicitly at least, not take the target too seriously and that the de facto target would be closer to 6%. Given that newly appointed Governor Urjit Patel himself was the key architect of the new regime, this was likely naive and, in its last three policy reviews, RBI has been unequivocal that it is targeting 4% CPI inflation on average. With ‘core’ measures of inflation sticky around 5% and measures of private sector inflation expectations even higher, the 4% target represents a stiff challenge.
Taking the MPC at its collective word, policy will need to be consistently tight to push core inflation closer to 4%. In turn, this means that the lion’s share of forecasters have been too sanguine about the average level of rates that are likely to prevail over the medium-term. The standard workhorse for thinking through these dynamics more systematically is, of course, the so-called Taylor Rule; a stylised representation of how central banks set monetary policy. The Taylor Rule argues that deviations from the ‘neutral’ policy rate should be driven by a more-than-proportionate response (1.5x) to deviations in inflation from target and a smaller response (typically 0.5x) to the output gap.
There is an emerging consensus that India’s neutral real interest rate should be 1.75-2%. Adding on the inflation target of 4% yields a neutral policy of 5.75-6%, suggesting that the current repo rate of 6.25% is mildly restrictive. Critically, inflation targeting needs to be forward-looking. It is prospective inflation and GDP growth that should drive the central bank’s reaction function. RBI’s April Monetary Policy Report sees CPI inflation at 4.9% by end-FY2018, while the current output gap of 1.25%-1.5% of GDP is expected to narrow gradually over the coming year. Plugging these forecasts into the Taylor Rule formula suggests that the repo rate should be in the region of 6.5-6.75% if RBI is sincere about its 4% target.
Certainly, unless expected inflation decisively pulls back to below 4.5% or the output gap widens further as the economy stumbles, the case for policy ease looks limited. All told, the trio of factors outlined above—demonetisation and its impact on liquidity, the sea change in the external environment and the stiff challenge posed by the 4% CPI target—have not only contrived to wrong foot most RBI watchers but has suggested for some time that the next move in the repo rate will not be down, but up.
The author was previously BNP Paribas’s head of Emerging Market economics and for the last two years has been the top-ranked RBI forecaster according to Bloomberg.