RBI monetary policy: Caution is key for the MPC

The MPC might want to consider the potentially V-shaped increase in growth and in inflation that could take place once the temporary effects of demonetization wear off

Photo: Aniruddha Chowdhury/Mint
Photo: Aniruddha Chowdhury/Mint

Both the pundits and punters got it wrong. They were wrong on Brexit, and they didn’t predict a Trump victory. As if that is not enough to confound you, in India, we had a major contraction of monetary base combined with a deluge of deposits in the banks. How then to reconcile a contractionary monetary shock that is leading to expectations of jumbo rate rates? The liquidity situation has caused the Reserve Bank of India (RBI) to raise the cash reserve ratio (CRR) stiffly to 100% on incremental deposits. Thus, these are not only interesting times, they are unprecedented, are full of uncertainty and beyond known models. The monetary policy committee (MPC) next week will have to work with many moving parts in deciding their next step, and this is just the second time it is meeting after it was constituted.

The Organisation of Petroleum Exporting Countries just collectively decided to cut oil output, the group’s first such decision since 2008. This will nudge inflation higher in India, since oil prices will move up. RBI’s household survey of inflation expectations is already indicating double digits in the next 12 months. The US Federal Reserve is almost sure to hike rates this month. In anticipation, the sovereign yields have gone up in almost all developed countries as well as some developing ones. Only India’s 10-year yield dropped by about 80 basis points (bps) in the past three weeks. The narrowing gap between India’s rates and US rates would have an implication for capital outflows and consequent rupee weakening. This is something the MPC must factor in its decision. Of course, unlike 2013, there is no rupee panic, and some weakening is a good thing. On real effective exchange rate (REER) basis, the rupee has been consistently overvalued for a prolonged period.

Prior to the demonetization decision, the Indian economy was cruising well in the first half of this fiscal, even as the investment activity has so far flattered to deceive. Consumption indicators were looking up, 2016 monsoon was normal and very well distributed, and exports were showing signs of life. Inflation had moderated and the benign effect of lower oil prices on fiscal and current account balances was clearly visible. But now, there will be demand contraction at least for a couple of quarters. The temporary liquidity surplus will add to margin pressure on banks. New borrowing and private investments are still not forthcoming, while older non-performing asset problems may exacerbate. Gross fixed capital formation has been very disappointing.

Hence, even as there are expectations of an aggressive rate cut from RBI, the MPC might want to consider the potentially V-shaped increase in growth and in inflation that could take place once the temporary effects of demonetization wear off. The likely firming up of oil prices, the already high household inflationary expectations and the potentially inflationary effect in the initial days of goods and services tax implementation would imply that medium-term inflationary risks are going to be lurking even as near-term outlook is softer. Also internationally, due to a quick run-up in US sovereign yields, and political events in Europe, global financial markets may remain nervous. And frequent risk-off episodes in the coming months cannot be ruled out. RBI may also like to save up on some of its ammunition for an eventuality where any of these global risks flare up into major crises.

The CRR step was already a hint in that direction. Since a good part of this additional liquidity is going to be transient, temporary liquidity management tools will be appropriate to deal with the same. The monetary policy will have to be guided much more by the assessment of the real economy. The economy needs to be guided out of the current demand shock, but in doing so, the MPC may well weigh on the side of caution. A 50bps cut will be seen as front-loading with little ammunition left for later. The MPC action will be watched, so will its assessment of the economy.

Ajit Ranade is the chief economist at Aditya Birla Group.

This is the second in a series of columns ahead of the RBI’s sixth bimonthly policy review on 7 December.