Does Urjit Patel’s appointment dim rate cut hopes?

Mumbai: With Urjit Patel’s appointment as the Reserve Bank of India (RBI) governor, it is advantage “hawks” in the Indian economy.

Raghuram Rajan, backed by Patel, has focused on bringing down inflation over the past three years, maintaining that price pressures must be brought under control for sustainable growth. As such, the balance of power under the Rajan-Patel regime was always tilted in favour of inflation control. With Rajan announcing his exit from the RBI in mid-June, some in the markets were hopeful that this balance will shift, opening up more room for interest rate cuts. This was visible in the way bond markets rallied soon after Rajan’s decision to step down as RBI governor.

Since Rajan’s exit announcement, the yield on benchmark 10-year bonds has fallen 38 basis points to 7.10%—the lowest levels since 2009. (One basis point is one-hundredth of a percentage point.) To be sure, a rally in global bond markets has also helped bring down yields, but the expectation (or hope) of a more dovish governor being appointed has aided the rally in bond prices. Bond prices and bond yields move inversely.

With Patel being named as Rajan’s successor, any hopes of looseness in monetary policy will likely be extinguished. According to a bond market trader, the 10-year yield could move higher by about 5 basis points on Monday when the market reacts to Patel’s appointment.

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The incoming governor is not only the architect of the RBI’s new flexible inflation-targeting framework, but is also seen as someone who has little tolerance for inflation overshooting the RBI’s comfort zones. At the current juncture, when consumer price inflation is skimming the upper band of the RBI’s 4% (+/-2%) inflation target, it seems unlikely that Patel will take upside risks to inflation lightly.

In the August monetary policy, the RBI had highlighted upside risks to inflation, even though it has maintained that monetary policy remains in an accommodative phase. Retail inflation rose to a two-year high of 6.07% in July.

Explaining the recent pickup in inflation, the RBI in its August policy statement said that the rise was mainly driven by food. Prices of vegetables, sugar and pulses have been on the rise again and that is pushing up both retail and wholesale inflation. “These developments fed through into households’ inflation expectations three months ahead, reversing the decline seen in the last two quarters,” the RBI said.

Given this, the Patel-led RBI will likely choose to wait and watch before bringing down interest rates any further. Most analysts expect only one more rate cut of 25 basis points this year, which could bring an end to the rate-cutting cycle that began in 2015. Since then, the RBI has cut rates by 150 basis points.

Even though Patel may stay away from any more rate cuts in the near future, the RBI has committed itself to an easier liquidity regime, which may help improve the transmission of past rate cuts to some extent.

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In April, the RBI said it would kill the liquidity deficit and move to neutral liquidity over a period of time. In August, the central bank said it has achieved about 40% of this target, adding it would continue to infuse cash over a period of time.

What remains uncertain is the exact time-frame over which this liquidity deficit will be neutralized. “... the medium-term objective to manage permanent liquidity in a manner that takes the structural deficit of around 1% of NDTL (net demand and time liabilities) to a position of broad balance, consistent with the stance of monetary policy, this will necessarily have to be achieved over a period of time,” Patel said in a conference call with analysts after the monetary policy review on 9 August.

While this may be monetary easing by stealth, a more direct form of easing through interest cuts may not be forthcoming in the early months of Patel’s tenure as RBI governor. For that, Patel will need to be convinced that the recent uptick in inflation is a temporary spike that will not feed into inflation expectations in a big way.

He will also build in any likely inflationary implications of the Seventh Pay Commission awards and of the implementation of the goods and services tax before he decides to pull the trigger again.

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“Over the next few months, Dr. Patel will need to keep a watchful eye on CPI inflation carefully. At 6.1% in July, it has risen to well over the RBI’s early-2017 target of 5%. Here again, we believe that healthy monsoon rains could reverse the recent spike in food inflation, opening up the space for a 25bp rate cut in 4Q. But we do not see space for further rate cuts beyond that,” wrote Pranjul Bhandari, chief India economist at HSBC Securities and Capital Markets in a note on 21 August.

“Over the last two policy meetings, Dr. Patel has discussed risks to inflation from second round effects of government wage hikes and possible short term inflationary impact of the Goods and Services Tax regime over the second half of FY18. More importantly, in previous writings, Dr. Patel has argued for orthodox fiscal and monetary policy for sustainable growth,” Bhandari added, while highlighting the limited scope for further interest rate easing in the current cycle.

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