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

India Monetary Policy: A Game Of Mastermind   


Today, the Monetary Policy Committee issued its fourth monetary policy statement for the fiscal year 2018-19. The MPC decided to keep rates on hold but changed its stance from “neutral” to “calibrated tightening”. This call certainly was a surprising one, as markets and economists were expecting a 25 basis point rate hike. The MPC defended its choice by emphasising the inflation targeting mandate of the Reserve Bank of india. This implies that the MPC will only look at the inflationary consequence of the sliding rupee and will be very reluctant to use rate hikes just for the sake of steering the currency.

In addition, the RBI stated that today’s decision is appropriate, given its inflation and economic growth forecasts and the financial conditions. Moreover, the RBI lowered its inflation forecasts somewhat and Governor Urjit Patel hinted that the central bank has already taken sufficient measures to tame inflationary risks, pointing at the back-to-back rate hikes in June and August, the changed policy stance, and the fact that rate cuts currently are off the table.

Q2 FY19: 4.0%
H2 FY19: 3.8-4.5%
Q1 FY20: 4.8%

GDP Growth
FY19: 7.4%

Taking A Gamble

Against the backdrop of a worsening current account deficit, surging oil prices, weakening rupee, continued tightening by the U.S. Federal Reserve and volatile markets, RBI’s focus on its 4 percent medium-term inflationary target might be considered narrow and prone to policy errors. The markets are obviously taking a broader view and responded fiercely. The rupee briefly breached the 74/$ mark, and the Nifty lost 2 percent.

India Monetary Policy: A Game Of Mastermind    

Moreover, if we solely look at inflation projections, the RBI has no crystal ball either and Governor Patel himself underlined that the risks are currently tilted to the upside. Sure, food prices are expected to remain benign, but core inflation of 6 percent is stubbornly high and Brent has hit $85/barrel. It is well known that India - as the largest net oil importer of all emerging markets - is feeling the pain of higher fuel prices. As a reminder, fuel price inflation rose by 8 percent in June and 8.5 percent in August. And there is more: inflation can be pushed higher by domestic factors (the output gap has closed and is moving in positive territory now), the unfavourable monsoon distribution, and higher minimum support prices for crops which the government announced in July.

Most ironic, the RBI’s decision to leave rates on hold may have deteriorated the inflation trajectory by spooking the market as the current rupee depreciation will result in higher import inflation as well.

There is no evidence to suggest that the exchange rate pass-through to Indian domestic inflation has suddenly ceased to exist. According to our calculations, rupee weakness since April has, and will, push inflation upwards by 0.6 to 0.8 percentage points and today’s call will certainly add a few tenths of percentage points to that.

India Monetary Policy: A Game Of Mastermind    

Also read: India's Central Bank Delays the Inevitable

A Game Of Mastermind

Besides the surprise move of the MPC today, we are also completely left in the dark as far as the MPC’s expected 2019 trajectory is concerned. In that sense, the dynamics between the MPC and the market increasingly starts to resemble a game of Mastermind.

I’m not referring to the intelligence of Governor Patel or any of the other MPC members here, but to the classic code-breaking game that many of us played as kids. For those unfamiliar with the board game, Mastermind involves one player as codemaker (i.e. the MPC), and the other as codebreaker (i.e. financial markets and economists). The codemaker chooses a pattern of four colour pegs (i.e. the policy rate trajectory) and the codebreaker tries to guess the pattern, in both order and color, within ten turns.

In order to win the game as codebreaker, two elements are crucial.

First of all, one needs the proper strategy and ability to read the mind of the codemaker to discover certain patterns. Does he/she favour the red (bearish) or green (bullish) pegs? Does he/she use multiple colour pegs (single hikes/cuts) or duplicates (back-to-back hikes, status quo)? Etc..

Second, one requires, of course, a little bit of luck.

If both aspects come together, then sometimes a game is settled within one turn. Today, we obviously missed our turn.

To show just how surprising the current call of the RBI is, take a look at the evolution of policy rate forecasting in a Bloomberg survey since last year.

India Monetary Policy: A Game Of Mastermind    

Up till today, our November 2017 forecast was in line with the RBI’s trajectory, although admittedly we have revised our colour combinations a few times in between. Consensus also got it right prior to each MPC meeting, although it is fair to say that a couple of more turns were needed (see light blue, pink dots and yellow dots).

What we want to illustrate here is that markets and economists were just getting the hang of the way the MPC is playing Mastermind, but today’s call seriously disrupts that pattern and could take market trust back to square one. 

Keep in mind that this is not the first time that the MPC has surprised the market.

The Fed Is Spoiling The Game

So what can we expect going forward?

As always, the MPC kept their cards (or pegs) close to their chest and did not say anything about expected future rate trajectory. In that sense, playing a game of Mastermind with the RBI is much harder than playing it with the European Central Bank or the Fed. The Federal Open Market Committee publishes a DOT plot which reveals the colour combination it has in mind before a game has even begun.

Besides a hike in December, the FOMC shows a median expectation of three hikes in 2019, which would take the Fed’s target range up from 2.25 percent at this moment to 3.25 percent ultimo 2019. Now the tricky part here is that markets and economists do not always concur with the colour combination that the FOMC has in mind. In fact, we argue that if the Fed does raise rates three times next year, it might invert the yield curve and the inversion of the yield curve has been a good predictor of recessions within 12 to 17 months. The market too doesn’t fully copy the colour combination of the Fed and expects a policy rate of 2.85 percent at the end of 2019.

The uncertainty about the Fed’s fund rate trajectory might explain why Patel and his fellow MPC members are reluctant to show their projected policy rate for 2019. 

One has to keep in mind that Fed chairman Jerome Powell is able to change the colour combination of the MPC after each FOMC meeting. Now, if the market finds out that Governor Patel has been switching pegs during a game, they might consider that cheating and refuse to play anymore. Today’s sell-off is a good example of how that might play out. Ultimately, if the FOMC does continue along their projected tightening path, we can definitely expect another round of stress in the emerging market forex space, which would surely require a fierce response from policymakers. Definitely one more powerful than we have seen today.

Hugo Erken is Senior Economist at Rabobank; Country Analyst for North America, Mexico and India — RaboResearch.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.

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