1. Even as the RBI pauses, interest rates are rising

Even as the RBI pauses, interest rates are rising

Given how sharply bond yields have risen recently, the rate cycle has already changed, and that will hurt growth.

By: | Published: February 9, 2018 4:58 AM
RBI, Monetary Policy Committee, inflation, inflation trajectory, interest rates, RBI interest rates Already, it’s clear from the runaway rise in bond yields that markets have a momentum of their own and don’t always wait for a cue from the regulator. (Reuters)

The Monetary Policy Committee (MPC) has chosen to hold policy rates for the present as also a neutral stance even as it awaits more information on the state of the economy. While expecting inflation to be a tad elevated in the near term—5.1% in Q4FY18—the MPC expects it to moderate all the way to 4.5-4.6% by end FY19, albeit with some upside risks. In other words, inflation, in its view should average around 5% in FY19. Consequently, the committee didn’t see the need to tweak rates just yet. Indeed, the Reserve Bank of India (RBI) is unlikely to tighten monetary policy unless inflation moves up well beyond 4.5%. However, the central bank flagged half a dozen factors that could alter the inflation trajectory. These include the second-round effects of the increase in the house rent allowances for employees in state governments, the fallout of rising commodity prices and the impact of the hike in customs duties. Indeed, the government needs to be careful it doesn’t let inflation get out of hand; after slipping on the deficit for 2017-18, the fiscal deficit for 2018-19 has been pegged at 3.2% against the 3% planned earlier. One big concern is the proposal to compensate farmers for their crops at the MSP, in the event they are unable to get the support price.

This scheme promises to be inflationary and while the government is yet to spell out the details of the payment mechanism and the total cost to the exchequer, this paper has estimated the additional tab could be upwards of `80,000 crore. There is no doubt that the available resources must be spent and invested to get the economy going and to create jobs. However, there is equally good reason for the government to be circumspect and not incur expenditure by way of populist measures that hurt the economy. The MSP scheme smacks of populism coming as it does ahead of the general elections in 2019.

Already, it’s clear from the runaway rise in bond yields that markets have a momentum of their own and don’t always wait for a cue from the regulator. Consumer inflation has edged up from 3.58% in October to 5.21% in December, and yields have jumped some 66 basis points in the last three months. The bond markets appear to be pricing in higher inflation driven by the prospect of higher government borrowings and from a proposed higher remuneration to farmers. In fact, money is becoming expensive in the corporate bond markets too and lenders such as Axis Bank and HDFC Bank have raised the interest rate on loans. This is unfortunate since the economy hasn’t really staged a full-fledged recovery yet and higher interest rates at this stage would hurt businesses. With investments already very limited, companies would shy away from taking on new projects.

The government itself would need to pay more for its borrowings. The worry is that banks, which have been rattled by the recent rise in the yields and whose portfolios have been badly bruised, may not subscribe to the bond issuances to the extent needed. The RBI has needed to cancel a few of the recent auctions, not a good sign. While RBI governor Urjit Patel has done well to not over-hype the issue, he must be a worried man.

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