The impossible trinity in macroeconomic theory states that it is not possible to achieve a fixed exchange rate, free capital flows and independent monetary policy at the same time. Any country will have to choose two of the three at a given point in time. The Reserve Bank of India (RBI) is no exception in dealing with this trilemma. Opposed to broad market expectations, RBI has made its choice clear in its latest policy statement—it intervenes in the market to curb volatility and not to defend the currency. RBI has reiterated its focus on managing inflation. The central bank did not hike the policy rate to defend the rupee. However, it changed its stance from ‘neutral’ to ‘calibrated tightening’. This essentially rules out the scope for any rate cuts.

A few months ago, many on the street were in favour of a weak rupee. Even former Chief Economic Adviser Arvind Subramanian had said that the rupee should be allowed to depreciate as a part of the adjusting mechanism. When the rupee has actually weakened, the street was looking for an interest rate hike to support the currency. While a rate hike might lend some support to the rupee, it might not be in the best interest of the economy at this point in time.
Indian economy is still in recovery mode. The growth for the first quarter of this fiscal came in strong at 8.2%, over a weak base. Even the sharp pick-up in fixed capital formation at 10% was aided by a low base of 0.8%. The recent CMIE data suggests that new investment pipeline remains weak. New investment proposals have been on a decline since June 2016. Revival of investment is still some time away. PMI is hovering in the comfortable range of 51-52, but not showing any signs of pick-up. Capacity utilisation is down again to 73.8% in Q1FY19 from 75.2% in the previous quarter. The benefit of low base will also wear off in the coming months for industrial production numbers. Excluding oil, imports growth in the fiscal so far lags behind exports growth. Passenger car and two-wheeler sales have slowed down. Higher rates of interest might actually curb domestic demand and delay the growth revival. Real policy rates have been on an upward trend since the start of 2018. This trend might intensify as inflation numbers remain low and the central bank undertakes tightening. The financial sector is already reeling under NPAs and stressed balance sheets of NBFCs. A rate hike would only make availability of credit more difficult and costly.

Headline inflation remains within RBI’s comfort zone, thanks to softer food prices. Core inflation excluding petrol and diesel has averaged 5.8% so far. This is expected to decline further when high-base effect sets in. One-year ahead households’ inflation expectations remain fairly well anchored, while three-months ahead have seen a pick-up in the last three survey rounds. The central bank has highlighted various factors and risks guiding its stance. First, MSPs fixed by the government at a minimum of 50% above the cost of production can impact food prices. Reports suggest that wholesale prices of kharif corps—cotton, chana, bajra, soybean and pulses—are trading below their MSPs. Much of this is due to the bumper harvest—a classic case of poverty amidst plenty. Second, oil prices pose an upside risk to inflation. The outlook for oil prices varies vastly as was evident at the recent Oil & Money Conference in London. Some analysts are looking at oil prices reaching triple digits, while others feel it will inch closer to $70. The oil market looks tight over the next 1-2 quarters, but prices sustaining close to $100 seems an unlikely scenario. Third, RBI also makes a mention of rising input costs. The Business Expectations Index as captured in the Industrial Outlook Survey shows only a marginal improvement in the third quarter of the fiscal. The survey shows that the respondents are less optimistic on demand conditions. Higher input prices might not be able to translate into higher retail prices if demand remains weak. The World Bank commodity index shows that barring the energy basket, inflation in non-energy commodity prices isn’t really picking up—it’s actually negative for the last two months. Of course, some inflationary impact will be felt because of weak rupee.

The concept of monetary policy asymmetry is well-researched and documented. Ashima Goyal, the member of the Economic Advisory Council to the PM, had earlier highlighted that “a policy-induced demand contraction affects output more than it affects inflation.” Due to prices being sticky downwards, firms will tend to respond to a contractionary monetary policy by reducing output rather than prices. Moreover, in the case of interest rate increase, banks will simply pass on the burden to borrowers and constrain credit, leading to a bigger decline in output. The opposite is true in case of an expansionary policy. Persistently high food and fuel prices feed into higher core as well as headline inflation through inflation expectations. However, by constantly overestimating inflation in the past, RBI itself ran the risk of higher inflation expectations and hence higher inflation (‘Why RBI has been overestimating future inflation’, FE, April 16, 2018; tinyurl.com/anujprachi).

The success of a rate hike as an effective policy tool to defend the currency is also not guaranteed—as has been seen in the case of emerging markets like Indonesia. Other measures like NRI deposit scheme are at RBI’s disposal, but they, too, should be used cautiously to avoid sending panic signals to the market. Rupee weakness is primarily led by global factors—US Fed rate hike, US-China trade war and high oil prices leading to widening of trade deficit. In the light of a strong dollar, as long as the rupee maintains its relative strength, it should be fine. Until the weak rupee is not having a significant adverse impact on inflation, RBI is unlikely to intervene in a big way. A weaker rupee will support export growth and should also act as a natural defence against imports to a certain extent. It is perhaps in the best interest of all to let RBI not lose its focus from inflation, and pursue an independent monetary policy with (partially) flexible exchange rate.