Graphic: Mint
Graphic: Mint

Drivers of RBI’s future monetary policy stance

RBI has helpfully laid out a laundry list of risks at the end of its statement, which includes higher support prices for agriculture, oil prices, rising input costs and pricing power and fiscal slippage

With the monetary policy announcement out of the way, the focus of the markets will shift to how the Reserve Bank of India (RBI) is likely to react in future. The central bank has clearly said we should expect “calibrated tightening" from now on, the extent of tightening depending on the inflation numbers. Simply put, interest rates will go up in future, though not necessarily at every meeting. RBI has helpfully laid out a laundry list of risks at the end of its statement, which includes higher support prices for agriculture, oil prices, rising input costs and pricing power, fiscal slippage, et al.

The monetary policy report (MPR) fleshes out some of these concerns. For instance, the average price of the Indian crude oil basket is taken as $80 for the second half of the current fiscal year. It averaged $77.88 in September, according to data from the Petroleum Planning and Analysis Cell. The USD/INR exchange rate for the second half of FY19 is assumed at 72.50, a level we have now breached. The combined fiscal deficit of the centre and the states is assumed to be 5.9% of GDP.

It is on the basis of these assumptions that RBI has projected 7.4% GDP growth for FY19 and estimated that CPI (Consumer Price Index-based) inflation will be 3.9% in Q3FY19 and 4.5% in Q4FY19. Any breach of these baseline assumptions, therefore, should change the central bank’s inflation estimates and, therefore, affect the stance of monetary policy. The details of these assumptions are given in the accompanying table. Investors need to keep a sharp lookout for any data that indicates deviations from these RBI estimates.

The MPR also provides some clues and numbers about how underlying factors affect inflation and growth. For instance, it says that a 10% increase in the international price of a barrel of oil for the Indian crude basket is expected to reduce growth by 15 basis points (bps) and push up headline inflation by 20 bps. The price level also matters—the same percentage increase at a higher price point increases the impact on inflation. For example, an increase from $100 a barrel to $110 a barrel could pull up inflation by around 22 bps. Perhaps more importantly in these times, RBI estimates that for every $1 increase in the price of a barrel of crude, India’s current account deficit could widen by $0.8 billion.

How will changes in the exchange rate affect inflation? Says the MPR: “Assuming a depreciation of the Indian rupee by around 5% relative to the baseline, inflation could increase by around 20 bps, while the likely boost to net exports could push up growth by around 15 bps." On the other hand, an appreciation of the INR by 5% could soften growth by 15 bps in FY19 and lower inflation by 20 bps.

What about higher minimum support prices (MSPs) for farm produce? The MPR says that “a first approximation of the inflationary impact of MSP increase... yields 29-35 bps increase in headline CPI inflation". But these estimates are highly tentative in the absence of information on the actual size and scope of procurement operations.

And finally, the MPR clearly says “the output gap has virtually closed in Q1:2018- 19" reflecting acceleration in the pace of domestic demand. This would mean that capital expenditure by firms will pick up soon, which could lead to a wider current account deficit, while it also underlines the risk of higher price pressures.