Let’s be clear about one thing. The monetary policy due on June 6 cannot and should not be a ‘business as usual’ response to domestic data flow. The moderation in oil prices might have stemmed the violent run on the rupee and indeed reversed its direction but there is no guarantee that prices will not flare up again. Other risks have unfolded in its wake. The political impasse in Italy has rekindled fears about the survival of the euro and presents a clear and present danger of periodic ‘risk-off’ episodes. Emerging markets with high dollar debt and large current account gaps have been continuously beaten down since the beginning of the year. A macroeconomic crisis in Argentina in early May that sent it scurrying to the International Monetary Fund for support turned up the heat on these markets with investors panic-selling in Turkey, Brazil, and South Africa, among others.
India’s external sector imbalances might not look as alarming as the most vulnerable of this lot but its problems—a widening current account gap and rising external debt—are similar.
Foreign portfolio investors have over the past couple of months voted with their feet against India with $6.6 billion flowing out of Indian debt and equity markets so far in the financial year 2018-19. This could intensify going forward.
The bottom line is that the RBI needs to send a clear signal to the market that it’s bulking up its defence against another ‘external shock’ that could push the rupee into another free fall, taking other asset markets down with it. How does it do this? Going by the copybook, this entails a combination of tight liquidity, that pushes bond and money market rates up, and an increase in the policy rate to ensure that the central bank is in step with the curve. Thus, a policy rate hike is certainly warranted in the June policy.
What about the RBI’s claim that it does not meddle in the currency markets except to iron out excess volatility?
This does not mean that it announces an exchange rate target at the beginning of the year or in its policy statements. However, fine-tuning its intervention strategy to signal that it is comfortable with a particular level or range during a period of intense volatility might make intervention more effective and save precious reserves.
Exchange rate management is perfectly compatible with ‘inflation targeting’. Former U.S. Federal Reserve Chairman Ben Bernanke described inflation targeting as ‘constrained discretion’ that could fall back on a wide range of tools including the exchange rate.
Defending the currency as part of its inflation management strategy becomes essential when the price of a key input like oil is high.
Despite the recent moderation in prices, we do not see it falling below about $70 to $72 for a barrel of Brent crude, much higher than the assumptions made by the RBI.
Furthermore, it’s not as if the RBI’s attempt to raise the ramparts against an external shock is inconsistent with what inflation conditions would warrant. Since the last monetary policy meeting on April 5, crude oil prices have gone up by 10 percent. For the baseline estimate, the MPC had assumed an average level of $68 to a barrel for crude oil in 2018-19. Given the way things have panned out, there could now be an upside of around 20-25 basis points to RBI’s inflation estimate of 4.7 percent for the year.
It is also important that the MPC responds to other risks to inflation that have materialised since the last meeting in April. Rising core inflation should be on top of the list.
While the mandate of the MPC relates to headline inflation, recent comments from some members have been focused on rising core inflation. This is a legitimate concern since core inflation is an accepted gauge of demand-pull inflation (really the only bit that a central bank can hope to manage through monetary tools). The 7.7 percent GDP growth print for the last quarter of 2017-18 corroborates the fact that demand is gaining traction.
While in the last meeting, the MPC recognised the revised formula that the budget promised (MSP = 1.5 times the production cost) as an upside risk, the central bank decided to keep this factor out of its baseline inflation estimates because of considerable uncertainty and debate about what the appropriate cost measure is.
That said, while there is no official announcement, the compulsions of impending elections—the major states that have ballots have a high rural population percentage—and recent statements from the government suggest that the definition of cost measure under the revised formula would include a range of factors, like the imputed value of family labour for instance, that were excluded earlier. This could translate into a 20-30 basis point higher inflation rate than what the RBI had assumed.
That said, while we believe that a rate hike is imperative we are not entirely sanguine that it is indeed a done deal. Some of the more dovish MPC members might not be willing to switch immediately from a ‘neutral’ stance to ‘withdrawal of accommodation’. They could favour a more gradual approach, ‘prepping’ the markets first with a change in commentary and finally hiking in August. However markets are primed for a rate hike and should the RBI dither, it could fall well behind the curve and soon find itself fighting a hard battle against prices. A battle that could perhaps be avoided or at least fought more easily if it hiked now.
Abheek Barua is Chief Economist and Tushar Arora is Senior Economist at HDFC Bank.
The views expressed here are those of the authors’ and do not necessarily represent the views of BloombergQuint or its editorial team.