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Calibrated, not combative

A 35-bps hike balances macro considerations while leaving room to act later, as against a 50-bps one.

RBI MPC august
The unceasing fog of global uncertainty would imply that the MPC members would have to bring in their risk manager’s hat to the August meeting.

By Samiran Chakraborty

The Monetary Policy Committee (MPC) in its August meeting is likely to continue with its gradual removal of policy accommodation through raising rates; the only question now seems to be of ‘how much’. There are alternating crosscurrents of persisting inflation and impending recession emanating from the global economy.

With the views swinging almost every fortnight, the unceasing fog of global uncertainty would imply that the MPC members would have to bring in their risk manager’s hat to the August meeting.

In the past, the MPC has shown its willingness to accept different unconventional (conventional being in the multiple of 25bps) quanta of repo rate changes. This has theoretically opened up the possibility of multiple possible outcomes in the August meeting, but here we will limit ourselves to discussing the possibilities of two—a 35bps repo rate hike versus a 50bps one. The “35bps repo rate hike” scenario could be seen as a proxy for “anything below 50bps” where the arguments would be similar.

The strongest argument in favour of a 35bps hike in the August meeting is the evolution of the inflation dynamics since the June MPC meet which might prompt the MPC to opine that the headline CPI inflation has peaked in the near term. Average inflation in the June-quarter (7.3%year-on-year) is already below the Reserve Bank of India (RBI) forecast (7.5% y-o-y) made in June. Even the July inflation is tracking ~7% based on high-frequency prices data, which bodes well for the 2Q inflation trend.

This provides some room to RBI to even lower its FY23 average CPI forecast (6.7%), but may be the central bank will skip this revision in the August meet and await some clarity from the outcome of the summer crops before it moves on this.

Global commodity prices have retreated from their recent peaks though magnitudes of fall have been different. Both demand-side factors (risks of a global recession) and supply-side easing have contributed to this commodity price decline. While crude oil prices remain close to RBI’s forecasted average of around $105/barrel, falling refining margins and the government’s intent to keep retail petroleum product prices from pinching  too hard have ensured relatively contained inflationary impact from energy prices.

The second-order impact from wages, which could have made inflation more entrenched, also seem to be limited. MPC could reiterate the lack of evidence of a wage-price spiral in India, particularly in rural areas, that could have necessitated successive 50bps hikes.

Another reason for opting in favour of a smaller rate hike could be the fact that there has been some stealth tightening through changing financial conditions. The surplus liquidity in the banking system is now lower than the pre-Covid levels, and the weighted average call rate (RBI’s preferred operative rate) had moved from below the Standing Deposit Facility (SDF) rate to close to the repo rate. This is a stealth tightening of 15-20bps, which might obviate the need for a 50bps hike in August.

We understand that part of the recent liquidity tightness could be frictional, and RBI has tried to ease the situation with some short-term measures, but we would not be surprised if the weighted average call rate staying closer to the repo rate (as envisaged in the original MPC framework) becomes the norm again soon.

The need for a stronger rate hike to act as a defence for sharp currency depreciation has also receded, for now. There is some immediate respite from the almost unabated dollar strength of the last year as markets perceive that peak Fed hawkishness is behind us.

It is too early to comment on whether this is a trend reversal in the dollar cycle, but the MPC can afford to avoid a large rate hike in the August meeting before further clarity emerges on this front.

Given a host of upside and downside uncertainties on the growth-inflation dynamics, a 35bps hike combined with a commitment to be data-dependent in the forward guidance might give MPC the much-needed two-way flexibility. If inflationary concerns rise again, MPC would still be able to move towards larger hikes in 2H2022 without losing credibility.

On the other hand, if inflationary concerns continue to ease, a 35bps hike now would be an appropriate bridge towards a more normal 25bps hikes in the future.

In addition, the RBI Governor has repeatedly emphasised on policies being calibrated. A 35bps hike now would fit perfectly in that framework of calibration.

What could be the reasoning behind a 50bps hike? Inflation still remains well ahead of target and RBI would most certainly breach its red line of three-consecutive quarters of above-6% CPI.

Moreover, while downside risks are rising, high-frequency activity data continues to suggest resilient economic activity, which can spillover to demand-side inflation. Against this backdrop, keeping real rates negative for too long raises credibility risk for RBI’s inflation targeting mandate if inflation expectations get de-anchored.

Another argument for a 50bps hike could be an urgency to move closer to the “neutral” policy rate when the external environment is extremely uncertain. The neutral rate is a somewhat fuzzy concept, where a perfect agreement is difficult but most people will argue that it is substantially higher than where the repo rate is today.

The August MPC meeting has the difficult job of assessing the pace at which to arrive at that neutral rate. On balance, we think that a 35bps rate hike will balance the different macro considerations while retaining the policy flexibility to act in the future.

The writer is Chief economist – India, Citibank.

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