An employee inspects a wristwatch. (Photographer: Kiyoshi Ota/Bloomberg)

Monetary Policy: A Delayed Rate Hike Won’t Be Worth The Wait

BloombergQuintOpinion

The market is moving towards the view that the Monetary Policy Committee might keep the repo rate on hold at 6.25 percent at its coming bimonthly meeting. Forecasts of an August hike were scaled back, partially, following a downward surprise in June inflation, steady crude oil prices since the latest policy meeting, and incomplete information on the likely impact of higher procurement prices/monsoon progress on future food inflation.

While Standard Chartered Bank continues to expect a 25 basis point hike taking the repo rate to 6.50 percent, we acknowledge the possibility of a status quo decision next week.

The MPC’s current ‘neutral’ stance gives it the flexibility to respond in a measured manner and does not bind it to deliver consecutive hikes.

We believe that the arguments for a 25 basis point hike now still outweigh those for a pause.

We expect the MPC to maintain a neutral stance, and to provide a cautious—and data-dependent—guidance amid lingering global and domestic uncertainty.

RBI Governor Urjit Patel, RBI deputy Governors NS Vishwanathan, BP Kanungo and  Viral V Acharya arrive for a press conference at RBI headquarters in Mumbai. (Source: Shashank Parade/PTI)
RBI Governor Urjit Patel, RBI deputy Governors NS Vishwanathan, BP Kanungo and Viral V Acharya arrive for a press conference at RBI headquarters in Mumbai. (Source: Shashank Parade/PTI)

Also read: Understanding The Men And Women Of India’s Monetary Policy Committee

Here’s the rationale for the projection.

Risks To FY19 CPI Inflation Still To The Upside

A simple extrapolation from the June Consumer Price Index print indicates that ceteris paribus, inflation might marginally push below the MPC’s annual 2018-19 projection of 4.65 percent (without including the technical impact of the house rent allowance hike).

However, past experience shows that such marginal deviations from expectations can quickly reverse in later months.

We should, therefore, refrain from reading too much into one data surprise.

Also read: CPI Rises Less Than Expected In June But Core Inflation Jumps

Meanwhile, several factors like the potential impact of a double-digit increase in procurement prices, a weaker currency, a narrowing output gap and fiscal slippage can only add and not subtract inflationary pressures. Oil prices remain another swing factor. While oil prices are steady, they remain at elevated levels. With core inflation elevated at 6.40 percent, the MPC is unlikely to pause its rate-hiking cycle now, in our view.

We forecast average core inflation of 5.90 percent in FY19, up from 5.0 percent in FY18.

Additionally, if the MPC sees a 25 basis point hike as inevitable in FY19—based on its inflation projections—the August policy meeting provides a perfect opportunity. CPI inflation appears to have peaked in June at 5 percent.

Hiking later, amid a downward inflation trajectory, could be challenging, particularly ahead of the festival/busy credit season and impending election cycle in December. 
Shops display discount offers prior to Diwali at Sarojini Market, in New Delhi, India. (Prashanth Vishwanathan/Bloomberg News)
Shops display discount offers prior to Diwali at Sarojini Market, in New Delhi, India. (Prashanth Vishwanathan/Bloomberg News)

Also read: Time Is Ripe for Second India Rate Hike as Inflation Risks Mount

Real Rates Are High, But Are They High Enough?

In August 2017, Reserve Bank of India Deputy Governor Viral Acharya indicated that the MPC’s preferred level for real rates (repo rate adjusted for projected inflation) is around 175 basis points. Based on the MPC’s annual CPI inflation projection of 4.65 percent, and assuming no upside risks to inflation materialise, real rates today are close to 160 basis points, not far below the MPC’s preferred level.

In the current uncertain global environment, however, any deviation from preferred real rates would need to be on the upside.

This is particularly true given that real rates in economies such as Indonesia, Brazil, and China are significantly higher than India’s. While a 25 basis points hike would probably not be enough to arrest the fall in the Indian rupee, pre-emptive action by the MPC could go a long way towards reaffirming its inflation-fighting credibility and reducing risks to macro stability, should risk aversion worsen further. India’s reliance on capital flows has increased significantly, and the current account deficit is set to widen to $70 billion in FY19. This leaves little room for complacency.

Indian two thousand and five hundred rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)
Indian two thousand and five hundred rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

While RBI officials have repeatedly emphasised, monetary policy is determined by the domestic inflation trajectory and is not by interest rates in other countries, the second-round impact of these rates on domestic inflation via the foreign exchange channel is likely to keep policymakers cautious.

A wait and watch approach, while not appropriate for a rate action, may be apt if the MPC is considering a shift in its monetary policy stance from neutral to tightening. Since we believe that current macroeconomic conditions do not warrant a series of rate hikes in India over next twelve months, awaiting more clarity on key risks like oil prices and trade tensions is justified before MPC shifts to a tightening bias.

This raises a related question.

Will two hikes in a row be inconsistent with MPC’s neutral stance?

Not really in our view. The MPC has been in neutral stance since February 2017 and has delivered a hike as well as a cut since then with an unchanged stance.

Last but not the least, money market investors will probably have to wait longer for an announcement on liquidity injection by the RBI. While the RBI has been conducting open-market operations (OMOs, or bond purchases to inject Rupee liquidity) over the past few months, its approach until now has been ad hoc. We do not expect the central bank to deviate significantly from this next week. We think large OMO purchases (around Rs 1.65 lakh crore) are inevitable in FY19 given higher currency leakage ahead of the election cycle and the sharp decline of the balance-of-payments surplus. However, this is likely to be a story for the second half of FY19.

Anubhuti Sahay is head of South Asia Economic Research, Standard Chartered Bank.

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