Dear RBI, you say it best when you say nothing at all
In line with market expectations, the Reserve Bank of India (RBI) maintained status quo in its fifth bimonthly policy review, thereby retaining the benchmark repo rate at 6%. This is the second consecutive policy review by the central bank’s monetary policy committee in which key rates have been left unchanged with continuation of an overall neutral stance on monetary policy.
Despite the persistence of neutral stance, domestic money market rates have climbed up since the previous policy review in October 2017.
—At the shorter end, 1-year CP (commercial paper) and CD (certificate of deposit) rate has moved up by 19bps and 15bps, respectively.
—At the longer end, 10-year government security and AAA corporate bond yield has moved up by 40bps and 23bps, respectively.
To be sure, the hardening of domestic money market rates is reflection of multiple factors—ranging from the bottoming out of domestic CPI inflation after it troughed out at 1.5% in June 2017, the 11% jump in international crude oil prices since the last policy review in October 2017, emergence of fiscal slippage risks for the central government, sterilization operations from the RBI in the form of open market sale of G-Secs, and gradual progress in monetary policy normalization in key advanced economies.
The culmination of all this has resulted in the swap market currently pricing in one round of 25bps rate hike from the RBI over the course of next one year.
While this could still turn out to be an eventuality, one should note that with recent implementation of structural reforms like the Insolvency and Bankruptcy Code, goods and services tax, and Real Estate Regulation & Development Act, India is currently an economy in transition with several moving parts. These structural reforms could potentially have dissimilar inter-temporal impact on both growth and inflation conditions in the economy.
While some of them could be disruptive in the near term, these reforms would undoubtedly usher in a sound formal institutional framework for a higher and sustainable growth in the medium to long term. Similarly, while the impact on inflation could be noisy in the near term, a gradual disinflationary impact across the supply side pillars of industry and services could be expected as the full impact of these structural reforms get internalized over time.
Till the dust settles, the central bank should remain observant of the underlying changes and design malleable policy actions as per the evolving conditions. The December policy review by the MPC of RBI makes an attempt in this direction. While highlighting the near-term inflation risks (and also raising the H2 FY18 CPI inflation forecast range by 10bps to 4.3-4.7%), the central bank also highlighted the role of seasonal factors and incremental GST changes that could potentially offset some of the upside risks to inflation. Going forward, a balanced assessment from the central bank will prevent any buildup of bias in markets’ interpretation of the neutral policy stance. At the current juncture, market participants have started focusing beyond March 2018 CPI inflation trajectory. Going into FY19, I believe two things would be worth being mindful of:
—Early simulations indicate a possibility of CPI inflation breaching the 5% level in June 2018. Since this would predominantly be driven by an adverse statistical base, it would be important for the central bank to calm market expectations in this case. Thereafter, CPI inflation in H2 FY19 is likely to trend lower in the 4.0-4.5% range as the impact of HRA also starts to taper sequentially. A transient breach of 5% on the upper side ought to be treated equally as the transient breach of the 3% level on the lower side, which incidentally did not elicit any aggressive monetary easing response in early part of FY18.
—Anticipated improvement in growth conditions in FY19 should necessarily be construed as a pickup in demand side pressures for inflation. As the impact of structural reforms start unfolding, there is likely to be an increase in potential output, with productivity gains playing a critical role. Hence, this could continue to keep output gap negative despite an actual pickup in growth conditions. At this juncture it is critical that market expectations do not run far ahead of the monetary policy stance and complicate signals for lending and borrowing rates in the economy. Unambiguous communication from the central bank would assume significance here. As the central bank has been doing over the last two reviews, prudent policymaking in this phase of economic transition would require playing with cards close to one’s chest with unbiased emphasis on the availability of all policy options.
Shubhada Rao is chief economist at Yes Bank.
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