The market seems to be quite sanguine about the outcome of the September-end monetary policy. The Reserve Bank of India?s focus on inflation is likely to continue and the repo rate is to stay on hold for the fourth consecutive policy. But an RBI policy can hardly be a boring affair! So, the focus will again be on the tone of the policy statement. Is the balance of risks tilting in any particular direction?
RBI Governor Raghuram Rajan, around the August monetary policy, has stressed in different ways the focus of the central bank on controlling inflation. The gliding path target of 6% CPI inflation by January 2016 has been re-emphasised along with the belief that there are no short-term tradeoffs between growth and inflation. Governor Rajan categorically stated that the markets were wrong in interpreting the June policy as dovish. He mentioned that, in the last few years, RBI took the foot off the pedal too quickly, much before inflation expectations have been reigned in properly. So, now he is keen to see a sustained decline in inflation before he decides to cut rates?all base effect driven decline in inflation will be ignored. He has also said that he doesn?t want to revisit the inflation problem every year. As a corollary of this monetary policy stance, he has indicated that he is comfortable reducing policy rates only when a series of rate cuts are visible, not just a one-off rate cut.
We expect that RBI will not alter this broad monetary policy stance in the September policy and reiterate a lot of what was mentioned around the August monetary policy. So, what are the new monetary policy issues that can find a place in the September policy? Or, in other words, what are the issues on which the markets will be hoping to get an answer to understand RBI?s monetary policy trajectory more clearly?
First, although the headline CPI has not corrected much from the last policy, other inflation indicators such as the core CPI and WPI have dropped substantially. Global commodity prices, particularly oil, have also softened a lot. It will be interesting to see to what extent RBI acknowledges this good news and mention whether inflation is now trending lower than its projected trajectory. Will the focus remain singularly on headline CPI or other inflation metrics also shape RBI?s overall view on inflation?
Second, in the August policy it was mentioned that there were ?upside? risks to the January 2016 CPI target of 6%. Any change in this characterisation is going to be quite critical. Also, markets will be watching whether RBI publishes its CPI inflation forecast beyond March 2015.
Third, until now, RBI has not discussed the issue of ?real policy rates? in detail, except for mentioning that it needs to be positive. In the last three months, real policy rates have turned positive (first time after the new CPI has started), and as CPI starts declining, real policy rates could become substantially positive in 2015. Looking at the phase of the economic cycle that the country is in, what will be the comfort level of RBI on real policy rates?
Fourth, will there be more clarity about the reaction function of RBI in 2015? Is it possible that if the leading indicators suggest so, RBI will start easing policy rates even before the CPI touches 6%? On the other hand, if there are still ?upside? risks to the January 2016 inflation target, would RBI decide to act early and hike rates now? Any indication of this reaction function from RBI policy could be market moving.
For headline CPI to reach the RBI target of 6% by January 2016, it is imperative to bring down the food inflation, which is running close to 10%. There are different competing theories trying to explain the persistence of food inflation?an aggregate demand shock from loose fiscal policy (for example, higher MSP, MGNREGA payments, etc), a cost-push inflation because of higher prices of agricultural inputs or a market micro-structure issue which has affected the distribution efficiency and created a large wedge between wholesale and retail prices. Probably each one of these explanations has some merit in it but it is quite obvious that it is in the hands of the government to address these issues. The monetary policy can do very little about them. With minimal MSP increases and hopes of a moderation in rural wages, the process has begun. However, RBI most likely will have to dig deep into its trenches and wait for more supply-side reforms, particularly on the distribution side. In this context, it will be important to understand whether the central bank is happy with the pace of reforms and what will be the areas where it would be looking for more action.
Continuity is likely to be the key of the September policy. Market expectations have been guided towards a long period of stable policy rates. We do not think that RBI will be in a hurry to change that expectation so quickly.
The author is managing director & regional head of research, South Asia Global Research, Standard Chartered Bank
