After two rounds of a hike in the policy repo rate, the Monetary Policy Committee (MPC) has announced a pause. The policy repo rate, which is meant to influence and transmit over time to the rate at which banks lend to borrowers, stands unchanged at 6.5 per cent. The MPC voted 5:1 to keep the rate with just one member voting for an increase of 25 basis points. The market expectation this time was of just such an increase but this did not happen. What did happen was a shift in the monetary policy stance – from a “neutral” stance to “calibrated tightening”, a term that has become the stuff of headlines in the last few days. This change of stance took many players by surprise.
What does this mean for the markets and for the common citizen? And why did this have to happen in the midst of what many are calling mayhem in the markets? Above all, what exactly is this animal called “calibrated tightening”?
The RBI message is simple: going ahead, in the near-term, there will be no reduction in the policy repo rate and if anything, expect a pause or an increase in baby steps. When the stance is tightened, liquidity available in the system will be kept on a leash, as it were. The markets will have no scope to play with any surplus liquidity. This, however, does not mean that the RBI will not inject liquidity. It will, as the lender of last resort, if it has to, to help banks maintain their reserve ratios. So surplus liquidity in the system will be systematically sucked out and the money market rates will be made to align with the policy rates. This is a stance delicately different from what may be called “blind” tightening, when the system is kept in deficit (so that inter-bank rates tend to inch up) or in neutral mode, when the RBI allows market forces to play out in terms of liquidity management.
There are questions on why the RBI should do this right now, when inflation looks benign and markets may need some help in terms of liquidity. The answer lies in not what the inflation numbers are showing now but in what the RBI and the MPC are reading in terms of data and inputs that show bubbles forming and the worry that comes along with some of these bubbles bursting and the hard impact this will have on inflation.
In the end, it is a mistake to look at inflation merely as a static number that gives us a good enough read of the situation. Inflation management is also about recognising risks on the road ahead. And the picture does not look good. Thus, the stance of the RBI is consistent with its mandate of keeping inflation in check while taking into account the volatile situation in which the decision has been taken. This is truly the art of inflation management and monetary policy making.
In terms of numbers, the inflation outlook was set out by MPC in the range of 3.9- 4.5 per cent for second half of current fiscal and 4.8 per cent in the first quarter of 2019-20. There are uncertainties and upside risks to retail inflation emanating from both global and domestic sources. These include (a) impact of the minimum support price provided by the government to farmers, (b) upward pressure from the vulnerable crude oil prices, (c) a volatile global financial market, (d) rise in input costs, (e) fiscal slippages both by Central and State governments.
A comprehensive and more informed assessment of the associated risks and uncertainties surrounding retail inflation has been set out in the Monetary Policy Report October 2018, which was released along with the MPC resolution. It has been recognised that anchoring inflation expectation is a critical input in the approach of flexible inflation targeting (FIT), which is the name given to keeping inflation at 4 per cent (+/-2 per cent). According to the urban household expectation survey, there has been a softening of inflation expectation over a one-year horizon. However, in the industrial outlook survey, RBI has portrayed a rise in input costs.
Growth for 2018-19 projected at 7.4 per cent is seen as good. But there are concerns like predominance of private consumption and the fear of fiscal slippages, both at the Central and State government level, due to forthcoming elections. Consumption-led growth is never sustainable. Fiscal slippages carry the risk of higher borrowings and crowding out of private investment.
Immediately, the impact of increase in crude oil prices is worrisome. The baseline crude oil price has been assumed at US$80 per barrel and it is projected that in the event of a global oil price increase by 10 per cent (US$ 88), inflation will increase by 20 basis points. Furthermore, if the Indian basket of crude oil prices increased to US$ 96 a barrel – 20 per cent increase- the inflation rate would increase by 40 basis points. Apart from the crude oil price, the change in the global growth front also would impact retail inflation in India. The global economy is surrounded by geo-political tensions consequent upon the rising protectionism and looming trade wars. In addition, normalisation in US monetary policy and fiscal stimulus by the US could have some dampening effect on global demand. Taken together, if global growth moves to a downward trajectory by 50 basis points, there could be some impact on retail inflation and it will move upwards by 10 basis points.
Exchange rate depreciation also stands out as a matter of concern. The Indian rupee has depreciated at a faster step than expected on account of rising trade protectionism, the threat of currency wars (countries engaged in protecting their home currencies to make it cheaper for foreigners), higher international crude prices, increase in interest rate in US and net outflow from the foreign portfolio investors. In the event the rupee depreciates by 5 per cent over the baseline (which is assumed to be Rs 72 per $1 US), inflation rate would increase by 20 basis points. The Monetary Policy Report of October estimates as regards the minimum support price that there could be pressure on the inflation rate by 20 basis points in case of procurement higher than estimated.
Notwithstanding the current benign food inflation situation, there are risks and uncertainties in the inflation outlook. Therefore, the clear message in the MPC resolution is that it will keep a close vigil on inflation.
R K Pattnaik is a former Central banker and Jagdish Rattanani is a journalist. Both are faculty members at SPJIMR. (Syndicate: The Billion Press)
