The Monetary Policy Committee (MPC) will have persuasive arguments either for continuing with a second consecutive hike in repo rate, or remaining on hold.
The Monetary Policy Committee (MPC) will have persuasive arguments either for continuing with a second consecutive hike in repo rate, or remaining on hold. Our own view is that the uncertainty in the current economic environment should tip the scale for a hold on the repo rate and a “wait and watch” neutral stance. Monetary policy, however, is about more than just the current situation: the signaling function of policy is forward looking and is articulated to anchor inflationary expectations at least a year ahead. The final decision—which is likely to be split this time, unlike the unanimous decision to hike in June—will hinge on how much further ahead on the tightening curve the MPC members might wish to position themselves.
The critical issue in the discussion will likely be: What has changed since the June 201818 review, when continuing with a neutral stance while hiking the repo rate was deemed appropriate (suggesting that the need for two consecutive hikes might not have been anticipated), given the then economic conditions?
The most significant change to have emerged was the actuation of the proposed increase in kharif MSP at a 50% markup over costs. However, the actual outcome of the implementation post food procurement post October 2018 is still uncertain as is the potential impact on CPI inflation.
As a counter weight, global macro and policy driven inflation risks have stabilised, at least for the moment. Oil prices have fallen to $72-74/bbl now, from the $76-78/bbl in the fortnight before the June policy meet. Risks to global growth and trade have increased, creating another drag on India’s exports. Metals prices have dropped sharply on concerns about a trade slowdown. In addition, China has now emerged as a wildcard, with the extent of expected stimulus and currency depreciation still unknown. But, things can change in any of these, in a very short time.
Our projected inflation trajectory over FY19 and FY20 is stable, although remaining firmly above 4%. The attached picture shows that headline CPI inflation will peak in June, and is likely to fall till November 2018, before rising again in Q4 FY19, and then averaging 5% in FY20, despite expected deceleration in core inflation.
In this scenario, when incremental inflation from fuels is likely to be limited, domestic corporate pricing power and the output gap will play a decisive role in the evolution of inflation, with stronger demand allowing a fuller pass-through of higher input costs. Current evidence of a growth recovery is mixed, but evidence of a closing output gap and pricing power remain. High frequency data suggest mixed signals, with IIP numbers at a middling level, and below peaks seen in the November-February period. Still, RBI surveys showed capacity utilisation was unseasonably high in December, and there exists anecdotal evidence that this had continued through to March (see the attached picture). In contrast, Purchasing Managers Index (PMI) numbers suggest only a weak demand recovery. Equity markets have become a bit frothy, although the exuberance is emanating from only a few large cap stocks and is not broad-based.
The MPC’s decision, of course, will be supplemented by the yet publicly unavailable RBI survey results on inflation expectations, capacity utilisation and order books of corporates, business conditions assessment, etc. If household inflation expectations have indeed further risen in the latest survey, that is a strong signal for a rate hike.
The fiscal environment is certainly a matter of concern. Though still early in FY19, signs of some fiscal stress can be seen. Even though GST and direct tax collections appear to be improving, our estimates suggest that expenditures have risen faster during April–July in FY19 relative to previous years. State government finances might also be vulnerable.
Although monetary policy formally has no inputs from exchange rate movement or volatility, the rupee is yet one more dimension in the decision matrix, being, if nothing else, a harbinger of global shocks. Many have argued for a rate hike as a defence against currency depreciation, but the evidence on this from both India’s 2013 as well as cross-country experience, remains largely unconvincing. RBI has multiple instruments and strategies to moderate volatility.
As is widely recognised, liquidity management over the years has become a de facto monetary policy instrument. Some would argue even more effective in transmission than rate changes. Monetary conditions have remained tight the past few months. All interest rates—short term CPs and CDs, GSECs, corporate bonds—have risen sharply over the past year. Cost of funds for banks and NBFCs have also increased, leading to a shallow but steady rise in bank lending rates. Consequently, the real rate is now significantly higher (at 2.3 percentage points) than the benchmark indicated in the past. Structural durable liquidity in H2 FY20 is likely to be even tighter, and market participants are anticipating heavy OMO purchases, the interplay of which, with the policy stance, needs to be given some thought. Cumulatively, the arguments above weaken the economic case for a rate hike now.
However, communicating the continuing “vigilance” on inflationary conditions will be crucial for credible signalling. Consider the policy options. Hiking the repo rate while changing stance to tightening (from the current neutral) might be disproportionate given the current growth-inflation tradeoff. On the other hand, a hold on both the repo rate and a neutral stance, while probably appropriate in the present economy, might be deemed to be seen falling behind the curve, unhinging expectations, and creating unwarranted demand pressures. The optimal signal is probably to hike the repo rate, while continuing to maintain a neutral stance. Another factor in a decision to hike or hold is also the timing. Given our forecast of falling inflation over July to November, a rate hike during the October and December reviews might be viewed askance. The danger, on the other hand, is that two consecutive hikes might be deemed inconsistent with a neutral stance, sending confusing signals on intent and action. The language of the statement will certainly be more hawkish, implying that further hikes still lie ahead, but not so hawkish as to raise concerns on further near-term repo rate hikes, and thereby market interest rates (unless inflation conditions actually worsen).
Tanay Dalal and Vikram Chhabra contributed to the article