Case for rate cut ambiguous at best
Trying to manage conflicting demands and challenges is often summarized as “The Juggle”. As the Reserve Bank of India (RBI)’s latest policy review approaches, new governor Urjit Patel and his monetary policy committee (MPC) would seem to have an unusually large number of balls in the air to manage.
The surprise victory of Donald Trump has shaken the global macroeconomic outlook, with his plans for bigger budget deficits, driving up US interest rates and reviving the US dollar’s bull run. Another 25 basis points rate hike by the US Federal Reserve following its 14 December meeting is now a shoo-in, with its guidance likely to signal at least two rate hikes more to follow in 2017. Emerging market currencies are inevitably wobbling. The Indian rupee is no exception. Down around 3% since Trump’s victory, it has recently touched a record low against the dollar.
A battery of idiosyncratic shocks also continues to buffet the Indian economy. The good news is that this year’s monsoon was good enough to spur a revival in crop sowing and is now driving down food inflation. With still-elevated pulse prices likely to fall, overall headline retail inflation—4.2% year-on-year in October—could easily dip below 4% in the next few months, well below RBI’s interim 5% target.
While the current inflation conjuncture is benign, substantial upside inflation risks lurk for 2017. The Seventh Pay Commission is set to exert sharp upward pressure on housing costs. The expected introduction of the goods and services tax (GST) will also likely generate a substantial bump up in services inflation. These two effects alone could easily add 2 percentage points to headline inflation next year.
Dominating all in the short-run, however, is the government’s “demonetisation” drive, which represents an almost unprecedented disruption to the Indian economy. Adding to Patel’s headaches is that the appropriate policy response by RBI is far from clear, with the shock generating both inflationary and deflationary impulses.
Real economic activity is clearly taking a short-run hit. How much so is necessarily unclear, but GDP growth could easily be hit by 0.5-1 percentage point in the current quarter, maybe more. On the other hand, demonetisation is flooding the financial system with unprecedented liquidity as bank deposits surge. At the time of writing, the banking system has already seen a net infusion of over Rs6 trillion since 8 November.
With the stock of the soon-to-be-abolished Rs500 and Rs1,000 notes worth around Rs14 trillion, the tsunami of liquidity should continue until close to the official deadline of 30 December. Effective interest rates across the economy have plunged as a result, with money market rates, bank deposit rates and corporate and sovereign bond yields all tumbling by up to 75 basis points.
But with money market rates starting to slide through RBI’s reverse repo rate of 5.75% (the rate at which RBI withdraws excess liquidity from the banking system and currently set at 50 basis points below the repo rate of 6.25%, at which RBI loans short-term liquidity to banks), RBI has now imposed an incremental 100% cash reserve requirement (CRR) on bank deposits received between 16 September and 11 November. Locking up an estimated Rs3.2 trillion, this temporary move, which will presumably be reviewed as part of the upcoming policy meeting, has pushed money market rates back up towards, and even above, the repo rate at least for the time being. Deposit rates, corporate and sovereign bond yields, while still in most cases around 50 basis points lower since 8 November, have also backed up.
Without the shock of demonetisation, the case for a further reduction in the repo rate appeared modest. Rising global rates, a wobbling currency, increased uncertainty and substantial upside inflation risks for 2017 should all trump the benign short-run inflation picture. Demonetisation inevitably clouds the policy calculus but, while consensus expectations have now swung sharply to anticipate a cut in the repo rate, the case for a formal reduction in the repo rate still looks ambiguous at best.
The surge in liquidity was already rapidly loosening monetary conditions until RBI decided to stop this dynamic in its tracks with the CRR hike. But, with several trillion more of deposits still likely to flow in before year-end, downward pressure on market rates should resume even if the incremental CRR increase is extended. If RBI feels looser policy settings are still needed to cushion the real economy in the short run, why not allow the continued surge in liquidity to start pushing market rates back down again?
In other words, RBI should accommodate a de facto policy easing rather than sanction a formal cut in the repo rate to 6% that risks being reversed next year if upside inflation risks crystallize. A reintroduction of market stabilization scheme (MSS) bonds—additional fixed-interest securities issued by the government—could be used to keep money market rates above the current reverse repo rate floor of 5.75%.
Patel’s “juggle” is clearly unenviable, but two things seem clear. Domestic and international factors suggest little room for a sustained monetary policy easing, while the uncertainty and disruption generated by demonetisation demand clear and effective communication from Patel on RBI’s strategy and tactics for managing the shock.
Richard Iley is the chief economist, emerging markets, at BNP Paribas.