Policy Day Guide: Four Charts That Explain The Complex Decision Facing The MPC
India’s Monetary Policy Committee announces its policy review today, against the backdrop of a complex domestic and global environment. Oil prices and U.S. interest rates are at multi-year highs, the Indian rupee is at a record low pressured by a widening current account deficit, and credit markets are nervous.
The MPC, in keeping with its inflation targeting mandate, will view much of this through the lens of inflation and growth.
The Inflation Picture
At the time of the August meeting, the MPC had projected inflation at 4.8 percent in the second half of the current fiscal. However, the last two readings on inflation have been lower than expected. Still, should a majority of the MPC members see the need to anchor inflation close to the 4 percent mid-point of the inflation targeting range, the committee could see enough justification to keep monetary policy tight.
The MPC has already raised the benchmark repo rate twice this year, taking it from 6 percent to 6.5 percent. In light of the prevailing uncertainties, the committee maintained a neutral stance till August.
Upside Risks To Inflation
Justification for a third consecutive rate hike, and perhaps a shift away from the neutral stance, could come from the rise in oil prices and the fall in the rupee between the August and October meetings.
The rupee has slipped 7 percent in the two months between the two meetings and brent oil prices have risen 15 percent. That will increase the upside risks to inflation in the coming months. Some of that upside may be balanced by a cut in domestic fuel prices announced by the government on Thursday. The Rs 2.50 per litre price reduction could have an impact of up to 10 basis points on headline inflation, said economists.
However, with global crude prices expected to remain elevated, the MPC vote may swing in a favour of another 25-basis-point hike. It may also choose to drop its neutral stance if it takes note of the rise in inflation expectations reflected in the RBI’s Household Inflation Expectations survey and the IIM Ahmedabad Business Inflation Expectations survey.
The Current Account Deficit Conundrum
The argument in favour of a steeper 50-basis-point hike in rates comes from an analysis of India’s current account deficit problem.
Higher rates can help in two ways at a time when an economy is running a high current account deficit. Higher interest rates can help rebalance savings and investments, which eventually reflects in the current account balance. They can also help draw in more debt portfolio flows by keeping the interest rate differential attractive. That could help in a year when India has seen outflows of Rs 66,000 crore.
However, the MPC’s mandate does not permit to take a multi-indicator approach. As such, the committee can only react to the current account deficit to the extent that the imbalances are expected to feed into inflation.
Restoring Credit Market Calm
The MPC may also need to be mindful of the tight liquidity conditions and the strains in the credit markets. Both could have a bearing on consumption demand, which, through much of the last two years, was being fuelled by easy credit availability.
The onus of managing liquidity, though, lies with the RBI. The central bank has stepped up government bond purchases under its open market operations. It has also provided a calendar for such purchases through the month of August. These steps have already helped bring system liquidity back towards neutral.
Should there be a need to take further steps to either inject liquidity or ensure the smooth flow of that liquidity, the onus for that would fall on the RBI rather than the MPC.
What Will Be The Verdict?
Most in the markets accept the need for tighter monetary policy at this stage.
Forty of 49 economists polled by Bloomberg News expect a 25 basis point hike in the repo rate to 6.75 percent. A CRR cut is unlikely as the RBI is managing liquidity conditions via open market operations.
A change in stance from ‘neutral’ to ‘withdrawal of accommodation’ is also not being ruled out, along with a split vote. While not part of the formal set of expectations, market whispers also suggest the possibility of some MPC members voting for a 50 basis point hike.
The MPC’s decision will be announced at 2.30 p.m.