The Rate Debate: Will The MPC Be As Divided As Economists?

Inflation. Growth. Rupee. Three key factors that will determine whether the monetary policy committee hikes interest rates or not. The problem is that neither of these factors make the rate decision an open and shut case, which could divide an already split committee even further.

Economists differ on relative weightage that the MPC may give to inflation, growth and the currency. Consequently, they differ on whether it’s time to hike rates.

BloombergQuint spoke to Sajjid Chinoy, chief India economist at JPMorgan, who argued that a rate hike is justified in either June or August. Indranil Sen Gupta, India economist at Bank of America-Merrill Lynch, argued the reverse and said that growth needs to be given a chance to revive before rates are hiked.

Inflation: The Core Problem

Rising core inflation is one of the factors cited by economists who say it’s time for a rate hike. Retail inflation rose to 4.58 percent in April and core inflation rose to 6 percent. The MPC’s inflation target stands at 4 (+/-2) percent, which suggests that inflation is moving away from the mid point of the target range.

One-year-ahead inflation is on course to meaningfully overshoot the RBI’s medium-term target of 4 percent, said Chinoy. He added that higher fuel prices are adding to “cost push” inflation, which will feed into final prices as a stronger economy is leading to better pricing power. In an inflation targeting framework, the monetary authority must take future inflation into account rather than just look at current inflation.

Sen Gupta took a different view. In his latest report titled ‘All we are saying is give growth a change’, Sen Gupta argued that while base effect will push up headline inflation, this will decline if rains are normal. “Fundamentals do not support higher inflation,” he said.

Growth: The Underlying Problem

In deciding whether growth needs support from interest rates, economists feel it is necessary to judge what the underlying problems are.

Sen Gupta believes that high real rates has been a part of the problem that has held back growth in the Indian economy. He pointed to a period of low and steady interest rates under then RBI Governor Bimal Jalan, when the Indian economy boomed. If you support the Indian currency using inflows via NRI bonds, you can avoid hiking rates and allow growth to strengthen, he argued.

Sen Gupta also noted the rise in bond yields over the past few months and said higher risk-free rates are leading to higher funding costs. “The last thing the Indian economy needs is rising risk-free hardening lending rates to push back recovery,” he said. Banks, too, have started to hike rates – a rarity for what is considered the ‘slack season’ for credit demand.

Chinoy has a different perspective on growth. Among the many issues plaguing the Indian economy, competitiveness may be one.

Is India facing a version of the ‘Dutch Disease’, he asked?

His argument is as follows. Lower oil prices starting 2014 created a ‘positive terms of trade’ shock for India. This led to a near 20 percent appreciation in the real exchange rate. Has this “impinged on the competitiveness of India’s manufacturing sector (both exports and import competitors)?, Chinoy asked. If so, then the policy response may be to allow the rupee to weaken and counter domestic inflation via higher rates.

Supporting The Rupee: Rate Hike Or NRI Bonds?

The MPC will meet against the backdrop of pressure on emerging market currencies. India has not been immune and has seen its currency weaken by more than 5 percent. Others like Indonesia have chosen to hike rates to support their currencies.

Will that work in India?

Chinoy pointed out that 42 percent flows in FY18 were ‘growth sensitive’ and 50 percent were ‘interest rate sensitive’. So higher rates, while driven by domestic inflation concerns, may aid stability in the forex markets.

However, Sen Gupta says that the stock of foreign portfolio holdings in India is dominated by equity ($470 billion) over bonds ($80 billion). Hence, they are more sensitive to growth than interest rates. According to him, NRI bonds are the answer. They were used effectively in the past and can once again come to India’s rescue, he argued.