India and monetary policy: Where to from here?
Three domestic factors will matter most for monetary policy—inflation, liquidity and the output gap
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It is a foregone conclusion that the Reserve Bank of India’s (RBI’s) policy committee will leave the repurchase, or repo rate steady this week. Back in February, when (January’s) Consumer Price Index (CPI)-based inflation was edging to a fresh low under the rebased series, it voted in favour of an on-hold decision and shifted to a neutral policy stance. Inflationary risks were flagged, along with a relatively positive view on growth despite the banknote ban. Little has since changed for the central bank to change its mind.
February CPI inflation was off its floor to 3.7% year-on-year from January’s 3.2% as the impact of demonetization and seasonal forces faded. March CPI is likely to rise further towards 4%, in data due later this month. Core inflation eased slightly in February but is still in the 4.5-5% range that prevailed for much of last year. Oil prices are down, rupee is up, pointing to benign imported pressures. Then again, commodity prices play a smaller part in influencing the direction of CPI inflation compared to the Wholesale Price Index.
Looking ahead, three domestic factors will matter most for monetary policy—inflation, liquidity and the output gap.
On inflation, fuel/commodity prices will stay beholden to the global environment, with movements in the highly weighted food component to matter more. Cyclical factors including a smaller increase in the minimum support prices, timely rains, lower rural wages and a negative output gap have helped keep food inflation below 5% in fiscal year 2017 (FY17), down from double digits in FY13.
To meet and maintain the 4% medium-term CPI target in FY18, contribution from food inflation will have to fall by another 150 basis points from the previous year—i.e. from over two percentage points in FY17 to 0.7 percentage points in FY18. This will be an uphill task in the midst of the fading impact of the banknote ban, uncertainty over this year’s monsoon, higher minimum support prices for selected groups and rural wages that are looking up. This could stoke households’ inflationary expectations that have been easing in recent months.
Headline CPI inflation is likely to average 5% in FY18 from FY17’s 4.6%. Apart from food, the other routinely sticky components, especially those with supply gaps—health and education— are likely to contribute to inflation. The core gauge, which roughly makes 40% of the inflation basket, has already reacted little to last year’s disinflationary pressures.
Next is liquidity, which is flush in the wake of demonetization and strong foreign portfolio inflows. It is important to tackle surplus liquidity as it distorts the central bank’s policy signals. For instance, short-term money market rates are way below the repurchase rate of 6.25%. Typically, the repo rate is the level at which banks borrow from the central bank. In this current state of excess, attention instead shifts to the floor of the policy corridor—i.e. the reverse repo rate.
Excess liquidity is still to the tune of Rs3.5-4 trillion, much more than the neutral balance that RBI is comfortable with. Stepped up government spending is likely to push this balance higher in this quarter. Surplus conditions have hindered the central bank’s currency intervention attempts to slow the rupee’s ascent and threatens to stoke price pressures (as and when credit growth picks up).
Talk of a hike in the cash reserve ratio to soak up this liquidity did the rounds until officials indicated that a new standing deposit facility was being considered to mop up surplus cash at a rate lower than the repo rate without collateral. The latter will be a significant change from the existing reverse repo facility, which faced limitations in soaking excess inflows back in 2005-08.
This tool is being used by many countries and its main benefit is that the central bank has an option to intervene in both directions, when needed, to achieve the operating interest rate target. This facility might have been unveiled this week, but we learnt that changes to the RBI Act are required first. It remains to be seen if the proposal is rushed through Parliament before this session ends on 12 April. Until then, open market operations and market stabilization scheme (MSS) bond issuances are likely to continue. The MSS ceiling for last year was raised from Rs30,000 crore to Rs6 trillion to offset the impact of the banknote ban. This year’s ceiling is yet to be utilized, beyond which an increase might be on the cards if no other durable measures are undertaken.
Finally, all eyes will be on the output gap. Gross domestic product growth hit a road bump in FY17 at 7.2% from 7.9% a year before. But growth is expected to return to trend next year on improving consumption, higher public sector spending and better export growth. Investment growth will trail as the deleveraging process in the corporate sector is yet to be completed.
In all, little has materially changed since February for the policy committee to change its course. Given risks to next year’s inflation trajectory, the rates are likely to remain on hold for the rest of the year. We also note that under the flexible inflation-targeting regime, RBI will not be required to hike rates immediately in case of a modest overshoot of its 4% target. Any sharp jump in inflation numbers and/or heightened volatility on the back of global uncertainties might necessitate a tighter policy bias. Risks of either are minimal at this juncture.
Radhika Rao is an economist at DBS Bank in Singapore.