Urjit Patel, governor of the Reserve Bank of India (RBI), centre, speaks during a news conference in Mumbai (Photographer: Dhiraj Singh/Bloomberg)

Inflation-Purist MPC Awaits Impact Of Past Rate Hikes Before Taking Further Action

India’s monetary policy committee’s decision to keep interest rates unchanged at its October meeting was based on lower-than-expected readings of inflation and the need to let the economy adjust to past rate hikes.

Discussion around factors like the role of interest rates in the currency markets or the impact of the recent turmoil across non-bank lenders was limited, showed minutes of the MPC meet released on Friday.

After two consecutive interest rate hikes, the MPC kept interest rates unchanged at its October meeting with a 5-1 vote. The committee, however, moved its stance from ‘neutral’ to ‘calibrated tightening’ to demonstrate its commitment towards bringing inflation down to the 4 percent mid-point of its inflation target of 4 (+/- 2) percent.

Lower-Than-Expected Inflation

Explaining his decision to go with the majority vote of a status quo on rates, RBI Governor Urjit Patel pointed out that inflation had moderated in the last few months. Inflation has now remained below the 4 percent mark for two consecutive months. Consumer price inflation stood at 3.77 percent in September. Patel also noted that rates have been raised twice by 25 basis points each.

Patel, however, added that persistent inflation risks justify a change in stance, which would communicate the message that a rate cut is off the table.

Recognising that inflation risks have been persistent, and to reaffirm the commitment to securing the mandated 4 per cent inflation target on a durable basis, it is apposite to change the stance of monetary policy from “neutral” to “calibrated tightening”. “Calibrated tightening” means that in the current rate cycle, a cut in the policy repo rate is off the table, and we are not obliged to increase the rate at every policy meeting. 
Urjit Patel, Governor, RBI

Deputy Governor Viral Acharya also highlighted the lower-than-expected inflation, particularly the downside surprise exhibited in the food inflation numbers.

“The seasonal pick-up in prices of vegetables and fruits in summer months was simply missing due to a combination of increased mandi arrivals, export policies and other supply management measures,” Archarya wrote in the minutes. This, coupled with a normal monsoon, has shifted the RBI’s food inflation projections significantly downward.

Acharya, however, highlighted that the upside inflation risk emerging from higher fuel prices, particularly against the backdrop of a widening current account deficit and financial market turbulence, cannot be ignored. Still, he voted to keep interest rates unchanged in order to allow “the economy to adjust to the past two back-to-back rate hikes”, while changing the monetary policy stance to communicate vigilance against any emerging inflationary pressures.

Overestimating Inflation?

Inflation has underperformed the RBI’s expectations over the second quarter of the current fiscal, leading to questions about the reliability of projections.

Defending the RBI’s inflation forecasts, Executive Director Michael Patra said that the projections were directionally correct but overestimated the levels of inflation.

With the downward level shift in the projections relative to the August resolution, especially during January-June 2019, it is reasonable to keep the policy rate on hold in this meeting and to monitor the cumulative 50-basis-point increase in June and August as it works its way through the economy.
Michael Patra, Executive Director, RBI

Patra, however, added that inflation is likely to trough out in September and rise thereafter. As such, monetary policy needs to move to high alert, he said, while supporting a change in stance towards ‘calibrated tightening.’

MPC Member Ravindra Dholakia, who has all along been arguing for a softer monetary policy stance, drove home the divergence between the RBI’s forecasts and actual inflation levels.

Dholakia continues to believe that the RBI’s headline inflation forecast for 12 months ahead is on the higher side. “This is also because the extent to which the RBI has considered the impact of MSP revision on inflation is unrealistically high in my opinion,” Dholakia wrote.

Rupee Impact On Inflation

Going into the MPC meet, a number of economists expected the widening current account deficit and the weakness in the rupee to be significant inputs into the policy decision. In the post committee press conference, Governor Patel had reiterated that the committee’s legislated mandate is one of inflation targeting. As such, most of the discussion was mostly restricted to the impact a weaker currency would have on inflation.

The views on this were divergent.

Chetan Ghate highlighted that the inflationary expectations could be at risk of getting “unanchored by both the 7 percent nominal depreciation in the rupee and the $13 a barrel increase in the price of oil, since the August 2018 policy.” Given that, the appropriate “risk-management approach” would be to act now, Ghate argued. He was the only member of the committee to vote for a rate hike.

Pami Dua also argued that higher crude oil prices and the weaker rupee could have “potential pass-through effects on inflation.”

Dholakia argued to the contrary.

It is the depreciation in Nominal Effective Exchange Rate which affects headline inflation, Dholakia wrote.

While there is a considerable depreciation of Indian Rupee against U.S. Dollar recently, the rate of depreciation is substantially lower in terms of trade weighted Nominal Effective Exchange Rate, because other currencies have also depreciated against U.S. Dollar. It is the depreciation in NEER that affects headline inflation. As a result, its impact on inflation is not likely to be very substantial.
Ravindra Dholakia, Member, MPC

Dholakia also argued that real rates in India are significantly higher than 2 percent based on his estimates. There is no justification for increasing it further by a rate hike at this point, he said.