Monetary policy: Uncertain times call for caution, not rate hikes

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Updated: June 4, 2018 4:06:26 AM

The 7.7% GDP growth numbers have added to the fears that growth is back on track, and the central bank must do something to prevent overheating.

monetary policy, april, RBI, GDP, indiaHow quickly things change! Just after the April monetary policy announcement, there was a strong undercurrent of a rate cut given the benign inflation projections by RBI. (Reuters)

How quickly things change! Just after the April monetary policy announcement, there was a strong undercurrent of a rate cut given the benign inflation projections by RBI. However, after the minutes have been announced, there is now a strong undercurrent of an impending rate hike by RBI, even as headline inflation is still stuttering at close to 4.5% and is expected to peak in June at 5%, and then start its deceleration. The 7.7% GDP growth numbers have added to the fears that growth is back on track, and the central bank must do something to prevent overheating.

First, a word on GDP numbers. Q4 GDP growth has accelerated significantly on the back of an increase in government consumption, even as private consumption continues to lose pace, dropping to 6.6% in FY18 from 7.3% in the previous year. In fact, the per capita PCFE has decelerated, indicating negative income effect across decile groups. In particular, nominal agriculture growth expanded by only 4.5% in FY18, against a nominal GVA growth of 9.7%. The crux of the low growth in agriculture sector was a low deflator (quarterly GVA deflator at 0.4%/GVA deflator at 2.9%), indicating significant softening of rural prices. Thus, there is indeed an urgent need to provide an income support to farmers/MSP price support, as it will create the much-needed cushion in rural demand that is still only showing only incipient signs of recovery.

We must not fall prey over here to calls of fiscal policy orthodoxies, as a jump in rural consumption will only help growth to be more broad-based. Hence, in a nutshell, there are still early signs of an impending recovery and all care should be taken to support it and not derail it. Simultaneously, we are now witnessing signs of an asynchronous global growth in the making. Japan’s economy contraction in Q1-2018 marked the end to eight straight quarters of economic expansion, which was the longest sequence of growth since 1989.

The latest surveys show that there is some early evidence of a slowdown in emerging markets export growth. Chinese exporters are reporting slowing order growth and flat export prices. The FTCR China Export Index is below the average of 55.2 during the previous 12 months, while order growth has dropped to a 10-month low and export prices failed to increase for the first time in seven months. Export growth of Korea has softened in recent months. All these indicate that Indian exports may have a tough time in FY19 and this may act as a headwind on overall GDP numbers.

Most importantly, with the recent fiasco in Italy, it must be remembered that banks across Europe have a sizeable exposure to Italian sovereign debt. For example, France and Spain are top exposures outside Italy. Further, Moody’s has placed sovereign rating on downward watch list with all possibility that Italy may be reduced to junk status after the elections. In this case, even if there is no default, banks’ financials will be affected.

Additionally, wage hike in the US continues to be muted (2.7% against 3.5% prior to 2008), with the employment-to-population ratio of prime age workers—aged 25-54 years old—is 79.2%, down from 80% in early 2007. The yield spread between 10-year and two-year-old US treasury is now at the bottom of recent range, an indication of early signs of slowdown, going forward.

So, global growth prospects remain a little uncertain, as of now. Against this background, the fear of a rate hike stems primarily from a faster-than-anticipated increase in core inflation. However, there are two observations. First, our internal estimates show that a part of the jump in core inflation can be explained purely by the base effect. For example, core inflation was at its nadir in June 2017, at 3.85%, and hence it is likely that core will cross 6% by June, but will bottom out after that. Hence, before the August policy, RBI will have justifiably enough reasons to be concerned. However, our estimates suggest that after adjusting for the unfavourable base, core CPI at 5.92% drops to 5.37% in April.

Second, headline CPI has jumped by 221 basis points over July 2017 and April 2018, of which core has contributed 98 basis points and non-core 123 basis points. Interestingly, of the 98 basis points, 60% of the contribution has been contributed by housing and transport—a proxy for crude—and only 19% health and personal care. So, is it then fair to say that jump in core inflation is more broad-based, as housing inflation could be just a statistical artefact and transport is because of oil, the outlook of which is shrouded in uncertainties?

This analysis indicates that only few items are contributing to the rise in core inflation and, hence, produce too much noise to clearly witness any signal. As RBI DG Viral Acharya rightly pointed out in the minutes that monetary policy needs to separate signal from noise with regard to data, we also believe that any decision on policy rates must be deliberated upon.

In the end, as the accompanying graph shows, volatility of 10-year G-Secs is currently at high levels, reminiscent of a taper tantrum and even the 2008 crisis. Such volatility in the bond market could result in financial instability, though such monitoring is not a part of an inflation targeting mandate (this is, in fact, the greatest critique too of inflation targeting!). But, in hindsight, RBI, by keeping the liquidity in tight leash, may have already given a signal to the market, and banks have also been raising the lending rates. In such a scenario, will it thus still be prudent to raise rates? Will it not tantamount to double signalling? Let’s wait for June 6 for such to unravel.

Group Chief Economic Advisor, State Bank of India. Views are personal

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