RBI believes both rural and urban consumption are both healthy, but the Q4FY18 GDP data makes it more than abundantly clear that government spending and investment alone is driving the economy, and that the private sector’s contribution is very limited.
Although retail inflation has been rising over the past few months and hit 4.6% y-o-y in April, given it has been barely two months since RBI lowered its inflation forecast for FY19 by as much as 50 bps, the central bank may have wanted to wait for some more data before it raised the repo rate. In fact, the inflation expectations of households that the central bank seems to regard so highly have rarely ever matched the real data, or even come close to it.
Also, as the RBI Governor has noted, the pass-through of wage costs and input costs to output prices remains muted, reflecting low pricing power for producers. While many bank economists have also argued for a rate-hike given the new inflation dynamics, it is hard to understand the central bank’s conviction that “domestic economic activity has exhibited sustained revival in recent quarters”.
RBI believes both rural and urban consumption are both healthy, but the Q4FY18 GDP data makes it more than abundantly clear that government spending and investment alone is driving the economy, and that the private sector’s contribution is very limited. The headline 7.7% growth for Q4FY18 is less than ordinary because it comes off a very weak 6.1% in Q4FY17.
Private final consumption expenditure (PFCE), which the Governor alluded to as evidence of a recovery, has actually clocked in a sub-7% growth for five straight quarters to Q3FY18; the Q4FY18 growth of 6.7% y-o-y comes off an anaemic 3.4% y-o-y rise in Q4FY17. Moreover, capacity utilisation in the first three quarters of FY18 was 71.2%, 71.8% and 74.1%, respectively, so, it is not clear how fast the output gap is closing – the Governor spoke of this in the context of inflationary pressures returning.
Given the several macro-economic headwinds—elevated commodity prices and rising interest rates—companies are already struggling to grow their top-lines. Since all evidence—including RBI’s KLEMS study – shows very few new jobs being created, the central bank should have batted for growth. To be sure, the Governor has left the policy stance neutral which gives the MPC enough wiggle room to move either way. However, raising the repo by 25 bps to 6.25%, at a time when banks are already hiking loan rates, cannot but send a hawkish signal to the bond markets.
Between August 2017 and now, the yield on the benchmark has surged by almost 150 bps, and the central bank also needed to reassure the bond markets on liquidity. It has conceded that surplus liquidity “moderated considerably in the first half of May and the system moved into deficit in the third week”. This is unusual in the slack season and, as the Deputy Governor pointed out, is partly due to the currency-in-circulation being above the trend-line.
While more government spending in June has pushed up surplus liquidity to Rs 90,000 crore, and the easier rules on the liquidity coverage ratio (LCR) will help, the response to auctions for gilts has been very lukewarm. RBI has done well to ask banks to start valuing state government securities more realistically, but it would have done well to do more to increase liquidity which is critical if bond yields are to soften.