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  1. Hawk or dove? Inflation targeting put to acid test

Hawk or dove? Inflation targeting put to acid test

With the rate hike(s) factored in, RBI’s inflation-growth outlook and associated policy path to its target will set the tone in August.

By: | New Delhi | Published: July 17, 2018 4:56 AM
The moot question is how should the MPC respond?

The flexible inflation targeting (FIT) regime, since its introduction, has had an easy ride. A dramatic collapse in international oil, metals and food prices ran coterminous with its early claim to success. To RBI’s credit, it resisted lowering the policy rate sharply when inflation hit rock-bottom. As inflation reversed, and, in particular, core inflation persisted above the 6% level, the monetary policy committee (MPC) mustered the courage to unanimously raise the repo rate by 25 bps to 6.25% this June. But it shied away from sending a strong message to the markets by retaining its neutral stance. The June meeting minutes revealed that the majority of MPC members did not think it necessary to change the policy stance as inflation was projected to come down in the second half of FY19.

There was an important caveat though. One of the listed upside risks: the revision of minimum support prices, or MSP, was yet to materialise. Since then, the government has announced steep hikes for 14 kharif crops including rice. Analysts estimate these MSP revisions could push up retail inflation by anything between 30-110 bps, subject to procurement decisions. This would mean that the RBI would have to revise its second half inflation forecasts upwards. We will have to wait and see by how much in its forthcoming August review!

For an inflation targeting regime, the quantum of one-time revisions wouldn’t be the only concern because MSP increases could very well be extended to rabi crops as well, and the seasons thereafter. The government’s policy intent appeared pernicious: commitments to raise MSPs matching 150% of the cost of cultivation (A2+FL) for the future, at a time when input costs are rising, has the potential to develop into a self-sustaining food price spiral with resulting impacts upon core inflation in the second round. No one should suffer a memory lapse—least of all the MPC—that steep rises in MSPs for cereals such as rice and wheat, by the previous UPA regime, were the principal explanatory variable that had triggered double-digit food inflation. The present MSP policy has only exacerbated such risks by extending these hikes to further crops.

Moreover, the costs of such operations—directly upon the central government’s budget, and indirectly, off-budget upon the balance sheets of Food Corporation of India (FCI) and other procurement agencies—will trigger fresh worries, as much as every farm loan waiver announced by a state government does, in a larger macro, fiscal deficit context.

The MPC may have to confront another trouble lurking on the horizon. The June inflation projections incorporated a normal monsoon to predict lower food price inflation. But so far, at least until the first fortnight of July, the IMD’s forecast of a normal, well-distributed monsoon temporally and spatially has proved way off the mark. Following an unanticipated hiatus in June, July rains have been uneven and inadequate. The national deficit remains at 8%, but this hides very worrying developments: rainfall deficiencies (-20% to -59%) in 12 meteorological districts in Northern and Eastern rice-growing regions, which could affect gross sown area and yields.

By August 1, 2018, when the monetary review is scheduled, much of the uncertainties attached to the monsoon progress would be clear. Hopefully, better rains in the next three weeks may overcome the deficit in precipitations, especially in the rice belt. But if not, food inflation runs the risk of going up much faster than currently foreseen.

These factors apart, the rupee could also come under fresh pressures: the June merchandise trade deficit widened sharply, net services exports contracted 8% in May, and FPIs continue to be net sellers in both equity and debt markets. Although difficult to gauge what should be the rupee’s fair value when most analysts are revising their current account deficit projections to 2.5-3% of GDP, the 36-currency, trade-based REER in June 2018, at 115.3, suggests a fair bit of flab to shed.

RBI has been intervening quite aggressively in spot and forward markets to support an orderly adjustment, expending close to $20 billion of reserves to mitigate volatility as per its stated objective. One hopes the central bank is not trying to set a target as global financial and real conditions have worsened with the onset of the US-China trade fight and escalated uncertainties about the second-round, chain impacts upon global trade and growth. Capital outflows from emerging markets persist and are expected to endure or even worsen; the steady rise of US core inflation portends sustained interest rate increases.

Even without going deeper into fiscal concerns (Centre and states), and the slow-paced resolution of bad assets in the banking sector, signs of fragility in macro-stability are distinctly visible. That these appear at a time when early signs of economic recovery are wobbling creates further complications in an election year.

The moot question is how should the MPC respond? Post the MSP announcement, many analysts are expecting the MPC to turn hawkish and lift up the policy rate 25 bps in August itself. A few—those expecting inflation to stay significantly above 5% in the second half of FY19—have factored in a third increase in October or December.

This would depend upon how the RBI projects inflation in this year’s second half, especially food inflation. If the central bank were to revise these upward, from the current 4.7% to 5% or a little above, a relatively dovish MPC could raise rates by 25 bps, but still keep a neutral stance, hoping inflation would ease in FY20. But, if inflation were to be projected at 5.5% or above, it would then be prudent to not only raise the policy rate 25 bps, but also change its stance to “tightening” so as to prepare the market for another hike, soon, to restore the real rate to 1.25%.

This would be a top call. With June headline inflation at 5%, anchoring expectations could prove diabolical with both global and domestic uncertainties turning out too volatile. For the first time, the FIT regime would come under a real test—to respond unhesitatingly to quell higher inflation expectations from getting entrenched. Inflation expectations were already close to double digits in the May round. Any further firming up could affect the MPC’s credibility as it is stable, anchored expectations that are indicators of credibility for an inflation targeting central bank.

Note that if markets are pricing another 50 basis points hike in interest rates upto December, resulting adjustments to growth projections will follow too. In its August monetary review therefore, RBI’s inflation-growth projections will be keenly scrutinised. Its outlook and associated policy path to the target will set the tone. Therefore, it is up to the central bank to navigate this creek without upsetting market beliefs and retaining credibility at the same time. Observers, too, will be keen to know if the MPC has the political space (autonomy) to respond swiftly, and if FIT’s early success was a victory of good policies or an illusion—maya , as they say in Indian philosophy!

 

The author is New Delhi based macroeconomist

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