RBI Policy Decision: A Fine Balancing Act
It is difficult to harbour strong convictions on monetary policy at the moment, given the sheer quantum of near-term macroeconomic uncertainty that is prevailing.
This is both on account of: (i) trying to gauge the macroeconomic implications of demonetisation in India, as well as (ii) assessing the fallout of global events, including both the strengthening of the U.S. dollar and the steepening of yield curves around the world after the U.S. election, and OPEC’s decision this week to cut production volumes, which has pushed up oil prices by 10 percent and serves as a negative supply shock to oil-importing economies such as India.
These events create opposing pushes and pulls for the Reserve Bank of India. Against this backdrop, it is hard to bang the table on what the RBI should or will do. Instead, it is instructive to first understand the trade-offs that the monetary policy committee will have to grapple with.
The Demonetisation Debate
We believe the government’s demonetisation move is a bold, institutional medium-term reform. In the near term, however, the key will be how the MPC thinks of the macroeconomic implications of demonetisation.
In particular, two questions will be fundamental. First, does the MPC perceive demonetisation to have a temporary (1-2 quarters) or a more enduring impact (4-6 quarters) on growth? Second, will demonetisation constitute more of a demand shock or a supply shock?
Even before the demonetisation, we had believed that there were modest downside risks to the RBI’s 5 percent inflation target for March, and therefore had pencilled in a 25 basis points cut. If the MPC believes that any growth shock is purely transitory, and therefore does not impact the medium-term inflation outlook or change inflation expectations, the odds are it will be relatively conservative and ease by 25 bps next week.
If, however, the MPC – which had already worried about slack in the economy at the October review – worries that the demand shock could endure for several quarters and potentially help reduce inflation expectations more sustainably, the odds of a more aggressive response would increase.
Qualitatively, there appear to be at least three channels by which the demonetisation is likely to impact growth. First, a temporary liquidity squeeze on households that could impinge on near-term consumption, since it may take time to remonetise the economy. Second, a negative wealth shock to the extent that some of the old tender is never returned to the banking system. Third, a disruption to production and supply chains.
Over the last few weeks, concerns around the second and third appear to have mitigated. The rapid pace of deposits (almost 60 percent has been deposited/exchanged with banks in the first three weeks) suggests the wealth shock may not be as large as feared, and this will likely give the MPC some comfort that any growth impact in the medium term is unlikely to be large. Also, food prices have not surged, suggesting no obvious disruption to food supply chains. The key, therefore, is the MPC’s view on how long it may take to remonetise the economy and how long any liquidity squeeze on households will bind.
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The Volatile Global Backdrop
These domestic considerations, however, need to be weighed against the prevailing global backdrop. Since the U.S. election, the dollar index has strengthened almost 4 percent, and 10-year U.S. Treasuries have hardened by 55 bps. Meanwhile, India’s 10-year bond has softened by almost 60 bps, causing the interest rate differential to narrow by almost 120 bps.
If the RBI cuts more aggressively (say 50 bps), and is seen to be front-loading any easing, one could witness foreign debt outflows, which could weigh on the rupee. To be sure, policymakers would not be uncomfortable if the rupee were to depreciate in tandem with other currencies (so as to prevent NEER and REER appreciation) but they would obviously like a calibrated depreciation, and not a disorderly one.
The counter-argument is a 50 bps cut could induce foreign equity inflows, which may partially offset the debt outflows. Furthermore, with India’s current account deficit tracking less than 1 percent of GDP, the balance of payment in surplus, and record foreign exchange reserves, sufficient buffers exist to contain any rupee fallout. Therefore, a second consideration that the MPC will have to grapple with is how comfortable they are to cut aggressively in the current global environment, with the dollar strengthening and emerging market currencies under some pressure.
Finally, the MPC will have to take a view on oil. OPEC’s decision to cut has pushed up oil prices by 10 percent over the last 48 hours. Is this sustainable? What is the level at which oil will be capped by a response from shale? These are questions the MPC will have to take a view on. How does this change the RBI’s inflation math? The last monetary policy review had pegged oil at $46 in its baseline, with every $10 increase expected to impact inflation by about 20 bps. Therefore, the recent $5 move in oil should not unduly impact the inflation outlook just yet, but the key is whether oil continues to creep up further.
50 Bps Rate Cut Not Ruled Out
Our baseline view is the RBI will cut by 25 bps on Wednesday, and keep open the option of more easing down the line. There is too much uncertainty about the macroeconomic impact of demonetisation, and the MPC would potentially like to wait for more growth and inflation data, to see if a stronger response is warranted. Furthermore, current global conditions (a stronger dollar, higher U.S. interest rates, higher oil prices) are likely to deter the RBI from more aggressive easing at this point in time. Ironically, a 25 bps cut with dovish guidance could well have more transmission on bond yields, than a 50 bps cut with reduced expectations of further easing.
That said, we do not rule out a 50 bps cut. If the RBI worries about growth prospects for several quarters, and therefore has more conviction that the 5 percent inflation target will be undershot, and believes it will get most transmission to bank deposit and lending rates at the current junction – at a time when banks are flush with liquidity – we won’t be surprised by a 50 bps cut either.
All eyes are on India’s newly constituted monetary policy committee, and the fine balancing act that it is faced with.
Sajjid Chinoy is Chief India Economist at JPMorgan. All views are personal.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.